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LQD: Central Banks and Unintended Consequences

by ChrisCook Sat Sep 20th, 2008 at 06:20:18 AM EST

More good stuff from the Creditary Economics Yahoo Group.

Gang 8

The banking expert Geoffrey Gardiner has this counter-intuitive advice for the Treasury and Bank of England....


Another ridiculous twist in this farce is that the central banks are lending like fury to raise the 'liquidity' (really assignable government debt) of the banks while stripping the 'liquidity' out again by funding government debts.

The public's 'flight to quality' ensures this, and the result is that US government bonds are higher than since 1940. I was at a lunch with the woman who runs the British National Savings schemes a few weeks ago and she said that the Northern Rock affair had caused her organisation to be overwhelmed with applications for National Savings products.

So the savings of the public are going to the government which is lending them back to the banks at extortionate rates of interest. The Bank of England's profits in the main go straight to the Treasury. One can imagine that some Treasury official, desperate to cover the government deficit might regard this as a good wheeze, but in the long run it must be ruinous to the country.

The 'liquidity crisis' could be solved by a suspension of issues of government bonds and National Savings products. Savers would have to put their money in the banks and central bank loans would be repaid.

Government borrowing would for a while remain unfunded and the government's new borrowing would therefore be reflected in large deposits by banks at the central bank, which in turn would be anxious to lend them out for a better return. They would do so but of course the liquidity level would remain high, and a multiplier effect would take place.

This is the obverse of standard anti-inflationary strategy. What governments are doing is pursuing standard anti-inflationary tactics at a time when the horror of deflation is close at hand. No-one in government remembers what deflation is like; they are too young. Nor do they understand that this is the way to deal with it.

What Gardiner did not say here, but has pointed out before, is that one of the key problems is structural.

Quite recently, the Treasury took over from the Bank of England - after 300 years of relatively trouble-free operation - the department that deals with debt management - the "Debt Management Office".

Since that point the DMO has been run by a Treasury which knows bugger all about the banking system, and even less about managing an economy, due to their use of the literally insane "Washington Consensus" monetary policy framework.

I pointed out here in the context of Northern Rock that far from losing the tax payer money, the tax payer was making £20 million per week from the mad strategy Gardiner refers to here, and said at the time was stripping the system of the true liquidity it needed. (Albeit, some of these profits are now being eroded by defaults).

The Treasury is of course rationalising its greed with the position that to issue new money in this way is "inflationary". They therefore miss the crucial point that the purpose of issuing new money is to prevent deflation, by replacing money destroyed by defaults. It therefore never enters the system at all (remaining "static" through being "tied up" in secured loans) and cannot create inflation.


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It therefore never enters the system at all (remaining "static" through being "tied up" in secured loans) and cannot create inflation.

But is it true that it never enters the system, or is it just delayed?

When I hear about the bailout proposal here in the US, I am concerned that-even if we were able to extend our debt by another $700bn-that would eventually lead to epic inflation at some point, when the current cash hoarding and flight to safety comes to an end. To battle inflation, we would have to raise interest rates, which would raise the cost of borrowing, as well as the interest payments on existing loans with free-floating interest rates.

In effect we would be in a very similar situation that we are now in regards to the viability of credit, except that instead of it being an artificial problem of banks hoarding cash, it would be the true state of the economy.

Am I off base? Please educate me here.

Thanks

by glacierpeaks (glacierpeaks@comcast.net) on Sun Sep 21st, 2008 at 04:43:53 AM EST
But is it true that it never enters the system, or is it just delayed?

It never enters the system, period. What does enter the system - over a period of years - is the rental value of the land and buildings against which the credit is secured, and this may offset any interest charged on Treasury debt issued to "fund" it.

But as Gardiner points out, if this "high powered money" actually is funded through debt issuance, Banks will remain "illiquid" despite having their balance sheet repaired.


When I hear about the bailout proposal here in the US, I am concerned that-even if we were able to extend our debt by another $700bn-that would eventually lead to epic inflation at some point, when the current cash hoarding and flight to safety comes to an end.

My understanding is that it would not.

Gardiner pointed out some time ago the example of the massive German debts held by British Banks prior to the First World War. When these defaulted on the outbreak of hostilities, they would have brought down the system, had not the Bank of England taken over the balances and quietly written them off against vast money creation for the purpose.

In those days the Bank of England knew what it was doing.

Creating new credit for the purpose of replacing old Credit is qualitatively different from creating new credit for the purpose of consumption eg Zimbabwe.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Sep 22nd, 2008 at 05:12:53 PM EST
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