Cooking the Books: The myth of magic money (2008)

The Cooking the Books column from the December 2008 issue of the Socialist Standard

One thing that the current banking crisis has done is to explode the myth about banks being able to create credit, i.e. money to lend out at interest, by a mere stroke of the pen. Events have clearly confirmed that banks are financial intermediaries which can only lend out either what has been deposited with them or what they have themselves borrowed or their own reserves. As the US Federal Reserve put it in one of its educational documents:

“Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money.” (Dead Link. p. 57)

Actually, banks don’t just borrow from individual depositors, or “retail”. They also borrow “wholesale” from the money market. It is in fact the difficulties they have experienced here that has revealed that they cannot create credit out of nothing.

Because some banks had burnt their fingers by buying securities based on sub-prime mortgages in America, other banks were reluctant to lend on the money market for fear that the borrowing bank might turn out to be insolvent. Which meant that one source of money for the banks to re-lend to their customers had shrunk. Or at least had become too expensive as interest rates had risen too high compared with the rate banks could charge their borrowers to allow them to make a profit or enough profit. So, deprived of this source of money, the banks had less to lend out themselves. Which of course wouldn’t have been a problem if they really did have the power to create money to lend out of nothing.

But at least one person was unable to see what should have been obvious. On 15 October the Times printed a letter from a Malcolm Parkin, in which he wrote:

“Only 3 per cent of money exists as cash. Therefore the rest is magic money conjured into existence, and issued as debt by banks, at a ratio of about 33 magic pounds to 1 real pound, by the quite legal means of fractional reserve banking. In a rising market, it follows that anybody able to create such money, at such a ratio, can soon get rich.”

The “fractional reserve” he mentions is the proportion of retail deposits that a bank keeps as cash to handle likely withdrawals. Fifty years ago in Britain it was 8 percent. But, as banks resorted more and more to the wholesale money market to get money to relend, the percentage of cash to loans became almost irrelevant. Parkin’s figure of 3 percent is the percentage of cash banks hold compared to total loans, including those based on money borrowed from the money market (which even on his definition is not “magic money“).

What a “fractional reserve”, or “cash ratio”, of say, 10 percent means, is that if £100 is deposited in a bank that bank has to keep £10 as cash and can lend out £90. Parkin has misunderstood this to mean that a bank can lend out £900 – and charge interest on it. Easy money, as he says, if it were true. But it isn’t.

The theory of “fractional reserve banking” is that an initial deposit of £100 can lead to the whole banking system, but not a single bank, being able to make loans totalling £900. The argument is that the initial £90 will eventually be re-deposited in some bank (not necessarily the bank that made the loan), which can then lend out 90 percent of this, i.e. £81, which in turn will be re-deposited, and so on, until in the end a total of £900 has been loaned out.

This is theoretically the case as one of the key features of capitalism is that money circulates, but what the theorists never emphasise is that this is based on the assumption that the same money is used and re-used to create new deposits. If this does not happen then the process cannot work or continue. So, the banking system has not created any “magic money” out of nothing. It is still dependent on individual banks only being able to lend out what has been deposited with them or what they themselves have borrowed – they cannot magically lend out vast multiples of this, as poor Malcolm Parkin assumed.

The Gold Standard and the crisis. (1931)

From the November 1931 issue of the Socialist Standard

Each of the periodic economic crises brings its own particular explanation. Publicists, orthodox economists, and politicians of every shade of opinion, are agreed that on this occasion the nigger in the wood-pile is the “gold standard,” or rather the failure of France and the U.K.A. to operate that standard “according to the rules of the game.” But despite their unanimity our scepticism is reasonable when it is recalled that there have been 16 crises during the past 150 years, and that a different explanation has been forthcoming each time. All of those crises, including the present one, have exhibited, in greater or less degree, the same features, viz., an accumulation of stocks of all commodities, a decline in production owing to the inability to sell the products of agriculture and industry at a profit, bankruptcies and banking difficulties as a consequence of the general fall of prices, falling money wages, growing unemployment, and for the mass of the population want in a time of superabundance.

This general similarity between one crisis and another points to there being a general explanation for all of them. Instead of which the explanations are always changing. This time we are told that the trouble has been caused by the attempt to operate the gold standard in a world split up by tariff walls and burdened by war debts. Can this explanation be accepted? To answer the question it is necessary to consider what the gold standard is and what its history has been.

First of ail it must be noticed that while the gold standard implies a monetary systen based on gold, it does not require that gold coins shall actually circulate. For all practical purposes there is no difference between a country whose monetary unit consists of a gold coin which circulates and is used as money in ordinary commercial transactions, and a country in which there is a paper currency convertible into gold. Both are on the gold standard. Before the war this country had, as its monetary unit, the sovereign, which passed freely from hand to hand in every-day transactions. Between 1925 and September of this year monetary settlements were effected in paper pounds which (above a minimum value of £1,700) were exchangeable into gold at a fixed rate. At both periods Great Britain was on the gold standard. What is necessary for a country to be on the gold standard is, then, not that there should actually be gold coins circulating, but that the unit of currency must, if it is a paper unit, be exchangeable on demand at some central institution, whether a bank, mint, or Government department, without charge to the holder, for a known and fixed amount of gold. Conversely any holder of gold must have the right to exchange it for currency, either coin or paper, at the same rate. Finally free importation and exportation of gold must be permitted so that a holder of currency who has to settle a debt abroad may do so by exporting gold obtained at the central institution in exchange for his currency at the fixed rate; while anyone having funds abroad must be able to convert them into the currency of his own country by importing gold and exchanging it for the currency of his own country at the central institution. In order to avoid complicating the question later it should be pointed our that free importation and exportation of gold is not necessary for this purpose provided that the central institution is compelled by law to buy and sell gold-backed foreign exchange, i.e., the currencies of other gold standard countries, at fixed rates corresponding to the amount of gold in the monetary units of the respective gold standard countries.

Given that these conditions are observed the country is on the gold standard, the significance of which is twofold. The first is that the value of the currency is the same as, and is dependent on, the value of gold. In other words, the amount of commodities that can be bought with £1 will be determined by the amount of commodities that will exchange for 113 grains weight of gold, that being the amount of gold for which £1 can by law be exchanged. Movements in the value of gold will be accompanied by corresponding changes in the purchasing power of the currency unit. As the value of currency reflects itself in the form of prices this is the same as saying that, under the gold standard, if the value of gold falls, prices will rise, and the amount of commodities which can be purchased with a £1 will diminish. Conversely if the value of gold rises, prices will fall. The second significant feature about the gold standard is that the general level of prices in two gold standard countries must be in equilibrium. This follows from the fact that, as has been pointed out, gold moves freely between the two countries. The price levels will not be exactly the same in the two countries for reasons which, however, are of no importance from the point of view of the present article and can therefore be ignored. The two price levels will tend to move up or down together, in accordance with changes in the value of gold.

So much for the value of a currency in terms of commodities, i.e., its internal value. Now let us consider the value of one currency in terms of another, usually referred to as its external value. Under the gold standard the value of one currency in terms of another, expressed in what is known as the foreign exchange rate, is fixed within narrow limits. For example, when this country was on the gold standard £1 was exchangeable by law for 113 grains of gold, and the American dollar was exchangeable by law for 23.22 grains. If 113 is divided by 23.22 the result is approximately 4.86. So that, apart from certain small variations that can be ignored here, the value of £1 was automatically fixed at 4.86 dollars. The exchange rate with francs, marks, etc., was similarly fixed.

To sum up the argument to this point we see the following consequences of an international gold standard :—

1. The value of the currencies of all gold standard countries is determined by, and fluctuates with, the value of gold.

2. Prices in all gold standard countries tend to move up or down together.

3. Exchange rates between gold standard countries remain stable.

After this brief survey of the principles of the gold standard now let us turn to its history.

As soon as division of labour resulted in individuals and social groups ceasing themselves to produce all the articles they consumed, a system for exchanging the products of various forms of human activity became necessary. In the first place recourse was had to simple barter. Cattle, for example, would be exchanged direct for corn or some other article. In the course of time direct barter became too cumbersome and a “universal equivalent” was evolved for the purpose of effecting exchanges. For a variety of reasons the universal equivalent that ultimately came to be generally adopted was a given weight of metal. In Western Europe this metal was silver. It soon came to be realised that it was more convenient to have coins of a known weight of metal instead of having to measure out quantities of the metal for each transaction. Gold coins were introduced in the 15th century, and finally this country led the world in making gold the basis of its currency, relegating silver coins to the position of “token” money, their value being fixed by law as a proportion of that of the gold coin. During the second half of the 19th century most of the leading countries of the world also abandoned the silver standard, and reorganised their currencies on a gold basis. When the war broke out in 1914 all the leading commercial countries were on the gold standard, and their currencies were gold coins winch actually circulated. At the same time there were in circulation bank notes which were redeemable into gold coin or bullion. The war saw the collapse of the old gold standard and the replacement of gold coins, as circulating media, by paper money. After the war, when the gold standard came to be restored, certain countries, including Great Britain, did not restore gold coins to circulation. Instead they retained their paper currencies, but made them convertible into gold, and permitted the export of gold. The notes, therefore, had the character of gold.

Another significant difference between the post-war and pre-war systems was that after the war certain countries did not revert to the simple gold standard, but to a developed standard known as the “gold exchange standard.” Under the pre-war system it had been the rule for each country to keep its own separate gold reserve for cashing notes. Under the gold exchange standard a country—Austria is an actual example— keeps part of its reserves not in the form of actual gold in the vaults of its own Central Bank, but in the form of balances with the Central Banks in other gold standard countries. As these balances could always be withdrawn in gold and taken back to the country of origin, it was thought that they were “as good as gold”; as indeed they were, so long as conditions remained normal. But the system had one important consequence. Gold deposited, say, by the Austrian National Bank with the Bank of England, was not only the basis of currency issued in Austria, but also provided the Bank of England with funds which it proceeded to utilise in this country. Under the pre-war system the withdrawal of gold from the Austrian National Bank would only have affected, directly, that bank. But under the new system the Bank of England would aiso be affected. In other words, under the “gold exchange system” events affecting the credit situation in one country would be likely to have immediate consequences in other countries, because the credit structure of more than one country had come to be based on the one lot of gold.

There remains another aspect of the post-war situation to be examined. The gold standard was never intended, as is so frequently alleged, to provide for the liquidation of an adverse balance of payments between two countries by the shipment of gold. Under the gold standard the function of gold shipments is to produce conditions in which an adverse balance of payments is eliminated. To reduce the matter to its simplest terms, the position can be explained as follows :—If people in country A are buying more goods and services from country B than B is buying from A, it must be because commodities are cheaper in B than in A. As the currencies of both countries are based on gold this is equivalent to saying that the purchasing power of gold is lower in A than in B. Consequently, gold will be sent from A to B. The gold for shipment will be obtained by changing notes into gold in A, and sending it to B. When it reaches B this gold will be converted into the currency of that country. The result will be to cause monetary stringency and a probable rise in the bank-rate in A, thereby lowering prices there. While in B the monetary situation will be eased and prices will rise. This will tend to discourage people in A from buying goods in B, and will encourage people in B to buy goods in A. This will continue to the point where A’s exports are increased and its imports diminished, sufficiently to eliminate the former adverse balance. From the foregoing it will be seen that under the gold standard the function of gold shipments is to cause adjustment of prices in the countries between which gold shipments take place, such that their international payments and receipts shall balance by the exchange of goods and services.

Owing to conditions arising out of the war gold shipments in recent years have been resorted to for the purpose of adjusting unfavourable balances of payments. What these conditions were can only be referred to here very briefly. Among the more important are the post-war system of tariffs, particularly in America, which prevented debtor countries from liquidating their indebtedness in goods, and compelled them to pay in gold; the flow of international payments in one direction, principally to U.S.A. and France, owing to Reparations, etc. ; and finally deliberate action by Central Banks to neutralise the effects that gold shipments would otherwise have had on the credit structure and the price levels. So that the adjustment of adverse trade balances by means of goods and services, in the manner discussed earlier, was impeded. In Great Britain, for example, the Bank of England consistently counterbalanced withdrawals of gold by what is known as its “open market” policy. In other words, when gold was withdrawn, and credit as a consequence became scarce, the Bank of England restored the position by buying securities, so that the funds that the money market lost as a result of the gold shipments were restored to it by the payments made by the Bank of England for the securities it bought. One of the main reasons why the Bank of England did this was probably that it was seeking to keep interest rates as low as possible in order that the Treasury should not have to pay more interest on its large floating debt. Whatever the reason may have been, the important fact is that Central Bank action frequently operated to make gold shipments of no avail, so far as concerns the adjustment of international balance of payments, by means of alterations in the relative amount of commodity imports and exports. This means that the gold standard in recent years was called upon to achieve purposes it was never designed to fulfil and which it was incapable of achieving; gold was used to liquidate adverse balances instead of operating to promote conditions in which adverse balances would disappear. Finally the inevitable happened. The gold standard broke down.

What will happen in the future to the gold standard need not be discussed here. For us the problem is, “Was the crisis caused by the failure of the gold standard ? Can it be overcome and economic welfare assured to all by a re-establishment of the gold standard, as we have known it or in some revised form, or by its supersession by some other currency system?” The answer to both questions is an emphatic “No.” The reasons for this answer must be reserved for a later article. Here it will suffice to point out that the recent acute world depression started, and has been most pronounced, in U.S.A. If gold is the cause of all the trouble this is rather strange seeing that U.S.A. was crammed with gold. Secondly, it is hard to see how the world in general,, and the working-class in particular, would have benefited if, before the crisis, there had been another £100 million, or even £1,000 million, of gold available in the world. What could have been done with it that would have overcome the fact that world stocks of all kinds, and especially of raw materials, were so high tthat they could not be disposed of at prices which would yield a profit ? The plain truth is that capitalism had again run up against its permanent and insoluble problem of being unable to distribute all the goods produced, because capitalist production is for sale at a profit and not for use. Therein is the cause of this, as of every other economic crisis of the past 150 years.

B. S.

Bubble troubles (2008)

From the May 2008 issue of the Socialist Standard

The intoxicating US housing boom has come to an end. Now the economic hangover has arrived.

With the collapse of the housing boom in the US what is likely, at the very least, is a prolonged crisis of the credit system. And as credit greases the wheels of capitalism this is no laughing matter for the capitalist class.

The Federal Reserve has been doing its best to ease the pain—the pain for the investment banks, that is. Barkeeper Ben Bernanke announced on March 11 that the Fed intends to generously fund the banks “rehab,” loaning them the incredible sum of $200 billion in return for the tainted “mortgage-backed securities” as collateral. This is very much like a doctor who prescribes a little hair of the dog to an alcoholic as a “cure” for a hangover. At best, such bailouts will probably only buy a bit of time.

And not very much time at that—judging from the recent string of collapses in recent weeks. On March 7, the investment fund Carlyle Group Corp. announced that it was unable to meet $37 million in margin calls from its lenders and a few days later it was reported that the 85-year-old investment bank Bear Stearns, which suffered huge hedge fund and mortgage-related losses, is being bought out by JPMorgan Chase in a fire sale, with money loaned by the Fed.

Far from calming the financial waters, the actions of the Fed have drawn attention to the severity of the crisis and also accelerated the decline of the dollar. Somehow, the system as a whole—the once inebriated economic body and its battered financial organs—will have to expel the vast quantities of toxic loans that are clogging it up. When other countries face this dilemma, the US has always the first to prescribe a bit of shock therapy, making use of capitalism’s natural function of regurgitation. For some reason or another, though, the US policy makers are sentimental when it comes to their own venerable financial institutions.

The US government that hasn’t lifted a finger to assist the massive number of workers who face foreclosure, but has acted quickly to pump money into the accounts of those who have made a good living picking the pockets of those workers. The direct impact of the crisis involving “subprime loans” (once more accurately referred to as “predatory loans”) has already led to hundreds of thousands of foreclosures, with the overall number of foreclosures up 79 percent in 2007 alone. Clearly, the US policy makers have every intention of shifting as much of the pain from the crisis onto the working class as is economically and politically possible.

Empty wealth

Some cold comfort to workers from the crisis, however, is that it rips great holes in some of the smug arguments that economists and politicians have tried to pass off as “common sense” (and which seemed plausible enough during the long speculative boom in the US that basically stretches all the way from the mid-1990s until recent months). For instance, it is becoming increasingly self-evident that the prices of many “commodities” lack any real basis and are thus “fictitious” prices to a large extent.

There is an important distinction, in other words, between the products of labour, which are the basis of any society and happen to take the form of commodities in a capitalist society, and the wide variety of things that have a price and thus take the commodity-form but are not the product of labour and thus lack intrinsic value. When capitalism is humming along, no one is very concerned with whether what is being bought and sold has intrinsic value or not, so long as it can be sold on the market. Thus, “mortgage-backed securities”—to take one example—were as good as gold for many years.

Now that the housing bubble has collapsed, however, such securities are being shunned, as it is clear that a great number of borrowers will be unable to meet their mortgage payments. The “value” (=price) of this commodity has plummeted, wiping out a vast amount of wealth that existed on paper, while leaving a hard lump of debt behind.

It is hardly surprising that people flock to gold during a crisis. That behaviour is not motivated by a human love of shiny metal objects. Rather, gold has served as the “general equivalent” or money historically precisely because gold has intrinsic value as a product of labour and that that value exists in a form that is inherently more durable and divisible than most other products of labour. 

In short, a crisis reveals the crucial distinction between commodities in the fundamental sense (as the capitalistic form of products of labour) and commodities in the purely formal sense (as anything with a price). Call it the revenge of the labour theory of value.

There is some irony in the collapse of the housing bubble revealing the distinction between intrinsic value and mere price. Because one of the initial attractions of the housing market to investors, after their dizzying experience with stock-market gambling, was that it appeared to be terra firma. After a vast amount of paper wealth was wiped out of 401k (retirement) plans and mutual funds circa 2000, it seemed that real-estate was a secure investment in a tangible asset.

But to describe a house as having intrinsic value turns out to only be a half-truth. Sure, the house itself has intrinsic value, like any other commodity in the fundamental sense just described, according to the socially necessary labour expended to produce it. In other words, the house’s value (as a structure) stems from the value of the building materials used and the amount of labour expended to assemble them.

However, in addition to the house itself, the price of the land upon which it is built represents a large part of the overall price—and the bulk of the price in the case of large urban areas. And that land has no intrinsic economic value (apart from whatever labour was necessary to clear trees or previous buildings out of the way so that construction could commence), only a price determined, since its supply is fixed, by the paying demand for it. In this sense, real-estate prices are a reflection—more than anything else—of the purchasing ability of the prospective buyers. So it is no surprise that those prices rose rapidly along with the increasing abundance of cheap credit.

Buyers in each particular housing market tried to convince themselves why the price of their own house would never fall (whether because of the desirability of their neighbourhood, the solid construction of the house itself, the strong local economy, or some other reason), but in fact there is no intrinsic value around which the price must gravitate, meaning that there is much room for the price to rise, or indeed, fall.

Profit-creation

Another central (but often ignored) fact which a crisis helps shed some light on is the origin of profit. During a speculative bubble, when mutual funds or housing prices are steadily rising, profit seems to arise magically from the very act of investment. No one is too bothered to ponder how this feat of alchemy is achieved. When the bubble eventually bursts, it may dawn on some that the actual creation of profit—rather than the mere transfer of money from one wallet to another—involves more than simply letting go of funds and then waiting for an even bigger sum to return in boomerang-like fashion.

And if the person bothers to investigate the matter further, it would become clear that profit is generated in the production process. It is there that surplus-value is generated as the difference between the value of the labour-power the workers sell to capitalists in return for their wages and the value those workers add to the commodities produced through their actual labour. In contrast, much of the profit that appeared to be created during the boom was in fact an expression of the expansion of debt.

The housing boom, like the stock market boom that preceded it, was praised as a way for workers to move up the social ladder, and it seemed that there was enough profit to go around to swell the ranks of the capitalist class. From today’s perspective, however, we see that workers are left in a worse situation than ever following the speculative boom, facing foreclosures and wiped out retirement funds. The only upward mobility in the end was for the money itself, which was coaxed out of the pockets of workers to pad the salaries of the much heralded “financial wizards.”

Granted, in any speculative bubble the expansion of consumption goes hand-in-hand with an increase in productive activity, but it is certainly not the case that the enormous gains made through speculation in certain activities reflect or correspond to an expansion in surplus-value created via production. Rather, the increase in the “value” (=price) of real-estate, stocks, or whatever the mania is centred on is fed by the speculation itself. Prices go up as more money is thrown at the object of speculation, and with those rising prices even more money is invested. But there is nothing to sustain the high prices once the speculative demand dries up. This is quite different from an increase of investment in productive activity that results in products containing surplus-value that are sold to realize a profit.

A comparison to eating, rather than the earlier hangover analogy, may highlight the distinction between mere speculation and investment in production. Simply put, speculation is not all that different from a person who consumes a large amount of food without performing any physical activity whatsoever. The result, unless the person enjoys a remarkable metabolism, is weight gain.

During the housing boom, the economy swallowed a tremendous amount of credit that for the most part was not directed towards productive activity, and this inevitably led to a flabby result. The speculative feast was good fun for those who partook of it, but now the heavy debt burden is making it hard for the capitalist economy to function, with the credit crisis also hindering investment in productive activities.

But it is not as if a “muscle-bound” capitalism is a lovely state of affairs either. As mentioned earlier, the surplus-value that arises from productive activity is nothing more than unpaid labour extracted from the working class. So there is no profit without exploitation.

A “fundamentally strong” capitalism (as it is called by those critical of finance capital but enamoured by capitalism itself) may conjure up an image of a healthy organism, but really it is more appropriate to picture a young Arnold Schwarzenegger prancing around the stage of a Mr. Universe contest clad only in his over-inflated muscles and surreal suntan. It is not true health or strength, but just the appearance of it. And just as Arnie worked out incessantly in the pursuit of muscles for their own sake, without any concern for their actual use, the productive activity under capitalism is only a means of building bigger and bigger profits, rather than being primarily a way to produce material wealth to meet the needs of society’s members in accordance with their collective and democratic will. There are all sorts of side-effects from the mad pursuit of profit, both in the short- and long-term, similar to how Mr. Schwarzenegger’s steroid-fuelled body-building in his younger years resulted in open-heart surgery by the time his muscles had sagged with age. 

Workers cannot be indifferent to a crisis, no matter how much we are disgusted by the predictable pendulum swing between “boom” and “bust” (and the sudden mood swings it causes among our capitalist rulers), because our lives can be directly influenced by today’s financial turbulence. But at the same time, we have no interest whatsoever in thinking up ways to put capitalism “back on track” or make it “healthy” again. Even when the system is in tip-top shape it works directly counter to the interests of workers.

The crisis will not miraculously or mechanically turn every worker into a socialist, as some pseudo-Marxists fervently hope, but it does at least create a situation where socialists may find workers more willing to consider an alternative to capitalism. It is up to us, as socialists, to present that alternative in a convincing way based on our understanding of the essential nature and limitations of the capitalist system.

Michael Schauerte

Gold Bores (2014)

Book Review from the June 2014 issue of the Socialist Standard

Gold Wars: The Battle for the Global Economy by Kelly Mitchell (Clarity Press, 2013)

The number of writers that are currently churning out books about ‘debt-enslavement’ and advocating currency-crank ideas seems to be rising faster than the price of the average derivative. One particular group of theorists are the ‘gold bugs’ who advocate gold as a safe-haven investment and tend to argue that only a gold-backed currency and international trading system is likely to stabilise the global market economy. Some hark back to the days when paper currency was ‘as good as gold’ and could be converted into the precious metal at a fixed rate.

Business analyst Kelly Mitchell, author of Gold Wars: The Battle for the Global Economy (Clarity Press, 2013) seems to be part of this group. In fairness, to those who are interested, there is a lot of fascinating (if sometimes technical) detail in his book about the operation of the precious metals markets in gold and silver. Part of Mitchell’s case is that the powers-that-be are frightened that physical gold and silver will emerge as real money again now that the currency in use across the world is fiat (token) money not backed by anything of real value like precious metals. He contends that economies using fiat money are prone to asset price bubbles stimulated by credit expansion from the central banks and wider banking system.

Mitchell repeats some of the myths about the power of the banks to create massive multiples of credit out of nothing that have been resurgent in recent years, and also trots out some of the highly questionable quotes often used to justify these views (see Socialist Standard October 2012 on these). He claims the financial crisis has now laid bare the mountains of debt and worthless paper being pumped out by banks and governments and that in order to stop a flight towards precious metals banks and governments have been manipulating the gold price downwards for years. This is to make it look less attractive and credible as an alternative to paper money and credit.

Market manipulation
It is certainly true that there appears to have been short-term market manipulation taking place periodically in the gold and silver markets, and this is where Mitchell clearly has accumulated much knowledge and evidence. Indeed, although Mitchell doesn’t describe it in detail here, the way the gold price for physical bullion is fixed in London each day – long the centre of the world gold market – is itself a gift to the conspiracy theorists. The five leading members of the London Bullion Market Association meet at 10.30am and 3pm each day to ‘fix’ in their words, the international ‘spot’ gold price. Until recent years this used to be done at the offices of NM Rothschild in the City of London (enough, of itself, to get the conspiracy theorists’ pulses racing) though these days it is done by Barclays, HSBC, Deutsche Bank, the Bank of Nova Scotia, and Société Générale. Private tele-conferences between these banks communicate information about demand and supply for physical gold until an average price emerges. When representatives of the five banks concerned are happy with the price, they each lower a miniature Union Jack flag on their desks – when all five flags are down the price is then fixed and relayed to other markets (including those for gold futures, options, etc).

Naturally, it is in this sort of environment that conspiracy theories flourish and there are a fair few in this book concerning precious metals and the power struggles around them. These include a bizarre historical one linking the JFK assassination with an apparent attempt by Kennedy to get the US Treasury to issue currency backed by precious metal (in that particular case, silver). A more plausible contemporary theory is that because there are now mountains of paper derivatives of gold, including Exchange Traded-Funds which are investments intended to mimic fluctuations in the gold price, there may not be appropriate levels of physical gold held by banks to satisfy the potential claims on it. In other words, investment banks have been busy creating financial products to sell derived from gold but which are not really backed by gold. Indeed, Mitchell and others have claimed that it is likely that the same gold is used several times over to ‘back’ derivatives – and that if the owners of these financial products demanded physical gold bullion in return for their paper certificates there would be nowhere near enough gold held in the vaults of the major banks and central banks to satisfy the demand, leading to financial panic.

Fort Knox
Compounding this is the mystery about how much gold banks actually have in their vaults, and about the quality of this gold. In 2009, the Chinese government received a shipment of gold from the US only to find that when the bullion bars were drilled they were partly tungsten, and it is thought that an increasing proportion of gold held in bank vaults is adulterated and of poor quality. Most major governments are very reluctant to have the gold held in their vaults audited for volume and quality – the US government has resisted for years an audit of the 4,600 tons of bullion it claims is held in Fort Knox.

What is for certain – and partly accounts for the title of Mitchell’s book – is that a significant shift has been taking place in recent years in the ownership of gold bullion. China and Russia have been significant buyers and so have some Middle Eastern states. This in turn seems to be part of a concerted attempt to undermine the US dollar and the American political and economic hegemony underpinning it, by establishing alternative trading mechanisms to the US currency. An example is that oil has been priced and traded in dollars for decades (the so-called ‘petro-dollar’), but many states are now showing signs of moving away from this system, including both Russia and China who have recently signed a deal to trade oil in the Chinese Yuan. This is indicative of the US losing its place as the dominant global capitalist power as happened to Britain after the end of the First World War. The dollar is seen as a far weaker currency than it has been in living memory and Mitchell claims that the lack of real gold backing it has been part of the cause.

Interesting though it is, there are nevertheless a number of problems with this book. One is that it is not especially well written and many of the charts and figures included are not properly explained or even reproduced in an intelligible way. The analytical faults, however, are even more serious. Like many in this field, Mitchell is prone to exaggeration and overlooks evidence which contradicts his case. For instance, if suppression of the gold price is part of a concerted attempt by major central banks and private banks to prevent gold emerging as an alternative to fiat currency as a representative of wealth, this is hardly consistent with the 800 percent increase in the price of gold seen in recent years, even if it is down on the highs it achieved in the immediate wake of the financial crisis.

Gold standard
More seriously still, Mitchell holds totally untenable views about monetary and trading systems based on gold (both in terms of national currencies and earlier international trading systems like the Gold Standard). Referring to the US Federal Reserve, he says ‘Since the Fed’s inception, the dollar has declined over 95%, the economy has seen a series of booms, busts, crashes, asset bubbles, and bank runs, that almost never happened under a gold standard, and unemployment has been far greater’ (p.110-111). But apart from the decline in the value of the dollar caused by inflation, none of this is true.

The idea that slumps, asset bubbles and bank runs didn’t happen under the Gold Standard of international trading payments and when currencies like the pound sterling and the dollar were convertible into gold on demand, is frankly ludicrous. They actually happened on a regular basis including the major 1907 financial crisis in the US when JP Morgan organised a bail-out of several major US banks that were about to fail, and of course the 1929 Wall Street crash and subsequent Great Depression. As well as banking crises and equity bubbles and crashes, there were also asset price bubbles in housing, land, commodities and a range of other assets. Asset bubbles, runs on banks and financial panics were commonplace throughout the period, and in all major countries. For example, the UK has experienced 12 banking crises since 1800, with only four of these since it came off the Gold Standard, while in the US the figures are 13 and two respectively (see This Time is Different: Eight Centuries of Financial Folly by Reinhart and Rogoff).

Mitchell has failed to understand that the expansion and contraction of the credit system that he is fixated on, and its attendant asset bubbles, is a reflection of the underlying trade cycle of the market economy and is not its cause. This instead is the drive by firms to sell commodities at a profit as if the demand for them is unlimited, leading to over-expansion of the booming sectors of the economy. This overproduction leads to cut-backs, hoarding and lay-offs and the monetary and credit systems are what transmits these effects throughout the economy more widely. An example was the over-expansion of the property sector in relation to paying demand in the US, UK, Spain and other countries which triggered the most recent financial crisis when credit lines and derivatives related to this turned sour. And as Marx pointed out in Capital in relation to the many crises that have taken place when monetary systems were based on gold, convertibility was no solution but just another means for transmitting financial chaos:

  ‘[A]s soon as credit is shaken, and this is a regular and necessary phase in the cycle of modern industry, all real wealth is supposed to be actually and suddenly transformed into money, into gold and silver – a crazy demand, but one that necessarily grows out of the system itself. And the gold and silver that is supposed to satisfy these immense claims amounts in all to a few millions in the vaults of the bank . . . with the development of the credit system, capitalist production constantly strives to overcome this metallic barrier, which is both a material and an imaginary barrier to wealth and its movement, while time and again breaking its head on it’ (Volume 3, p.708).

Indeed, whether the market economy operates with a monetary system tied to gold or not is effectively irrelevant so far as its underlying trade cycle is concerned as this cycle occurs irrespective of the precise monetary conditions, which influence the surface froth and bubble but little else. It therefore follows that tinkering with the monetary system is illusory as a solution to this problem of periodic booms, crises and slumps. In fact, it is partly because the international Gold Standard and also convertibility of notes did not solve these very problems (and in the minds of many economists even exacerbated them) that they were abandoned.

The only change of significance since token money (paper notes, etc) has not been convertible any more into gold at a fixed price has been that this has allowed a massive expansion of the note issue to take place. Over time, gold as a real store of wealth and a product of human labour became the means by which all other commodities and services produced by labour could be measured – in this sense it was ‘real money’. If paper tokens were introduced to circulate on behalf of gold, representing it in fixed quantities, these paper tokens acted as money (as ‘good as gold’) and so were representative of the social wealth embodied in commodities more generally in the economy.

But when convertibility was suspended this allowed paper money to be issued far in excess of the amount of gold that was representative of the wealth being produced by society – and this phenomenon has been the source of the massive currency inflation that has occurred across the world market economy since the 1930s, massively eroding the purchasing power of the dollar, pound and other currencies. It means notes and coins in circulation are no longer tied in any way to levels of production and trade in the economy. In this respect, any move to tie paper money back to gold would in all likelihood halt inflation – but it would do nothing whatsoever to halt the market economy’s periodic crises and slumps, like the recent one, that have caused so much misery across the world. Only the abolition of prices, credit and money itself can do that, enabling social regulation of production and free access to wealth. In such circumstances, gold will no longer be stored in bank vaults (as these will not exist) and can instead be used productively and creatively rather than as an object of financial speculation and power-broking. And that situation will represent a golden opportunity for us all.

Dave Perrin

Banks, money and thin air (2009)

From the January 2009 issue of the Socialist Standard

An urban myth is circulating on the internet that banks have been creating money out of thin air.

Those who have seen the cult film Zeitgeist and its sequel Zeitgeist Addendum, popular amongst conspiracy theorists and others suspicious of governments and banks, will have heard recounted the argument that banks can somehow create money out of thin air by the stroke of a pen or, these days, by the touch of a computer keyboard.

In Zeitgeist Addendum this argument is based on what is stated in an educational booklet published by the Federal Reserve Bank of Chicago. Entitled Modern Money Mechanics it first came out in 1975 and has gone through several editions.

Zeitgeist Addendum begins by describing how it thinks the Federal Reserve Bank (the “Fed”) creates money. If, it says, the government wants more money then, through the Treasury, it creates Treasury bonds which it exchanges with the Fed for currency notes of the same face value; as the government has to pay interest on the bonds this adds to the National Debt and so is “debt money”. Both the Treasury bonds and the currency notes have been created out of thin air.

This is one way of putting it but it is misleading. It is rather the other way round in that the initiative to create more currency comes from the Federal Reserve Bank. Once it has decided that more notes are needed it asks the Treasury to print them (for which the Treasury charges). The normal way these get into circulation is by the commercial banks converting into currency some of the reserves they are obliged to lodge with the Fed. Modern Money Mechanics explains:

“Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve balances) in the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve requirements. A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance” (p. 4).

In any event, both the Treasury and the Federal Reserve are part of government so we are talking about internal state accounting arrangements. It is, however, true that the new currency has been created out of nothing. Since it is not backed by gold and convertible on demand into a pre-fixed amount of gold, it is what in the US is called “fiat money”, that is, money created by a mere act of State.

Modern Money Mechanics does not in fact have much to say about currency creation but concentrates on what it calls “money creation”. It draws a distinction between “currency” and “money”. This is explained clearly enough on the first page of the booklet where money is defined as currency plus bank accounts with a cheque or debit card; which is M1 in the jargon (“In the remainder of this booklet, ‘money’ means M1”).

Congressman Ron Paul, from Texas, a critic of “fractional reserve banking” and advocate of a return to a gold-backed currency, has an even wider definition of “money”:

"M3 is the best description of how quickly the Fed is creating new money and credit. Common sense tells us that a government central bank creating new money out of thin air depreciates the value of each dollar in circulation." (27 April 2006, see here).

M3 includes other types of bank deposits and liabilities not included in M1. In claiming that all new money created by the Fed depreciates the dollar he is overstating his case. All the US currency (but, as we shall see, not bank deposits) is created “out of thin air” but an increase won’t lead to a depreciation of the dollar as long as it corresponds to an increase in the amount required by the economy for its various transactions (paying for goods and services, settling debts, paying taxes, etc). It is only currency issued in excess of this that will cause a decline in its value and so a rise in the general price level.

Everybody accepts that cash (currency, notes and coin) is money. Some might be prepared to include cash deposited in banks as well. But Modern Money Mechanics definition of bank deposits is wider than this. It doesn’t mean just deposits by people of the money they already possess but any account for which the holder has a cheque or debit card, i.e. including credit lines granted to those who banks have lent money to (so enabling Zeitgeist to go on talking about “debt money”):

“Checkable liabilities of banks are money. These liabilities are customers’ accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by banks are credited to borrowers’ accounts” (p. 3, emphasis added).

So, when it talks about “money creation” it is not talking about currency creation but mainly about “bank deposit” (in the above sense) creation.

The Federal Reserve booklet goes on to explain what “fractional reserve banking” involves and how it can lead to the creation of more “money” in the sense of more bank deposits. Banks, it explains, have learned that when cash has been deposited with them they only need to keep a part (a “fraction”) of it as cash as a “reserve” to deal with likely cash withdrawals; the rest they can lend out. What this fraction is depends on the circumstances, but historically it has been around 10 percent.
On the booklet’s definition, in making a loan a bank is “creating money” as their loans will take the form of creating a new bank deposit as a credit line which the borrower can draw on as if they had made a deposit of their own money (except they will be paying interest on it). The booklet then asks “What Limits the Amount of Money Banks Can Create” and answers that this depends on the cash reserves it has decided to hold or is required by law to keep.

It is here that Modern Money Mechanics, by suddenly shifting from what an individual bank can do to what all banks together (“the banking system”) can, opens the way to the misinterpretation of people like Ron Paul and the makers of the Zeitgeist films that banks too can create “money” out of thin air. The booklet explains that US banks are required by law to keep a “fraction” of deposits as “reserves” in its vaults and/or a balance with the Fed, and says:

“For example, if reserves of 20 percent were required, deposits could expand only until they were five times as large as reserves. Reserves of $10 million could support deposits of $50 million” (p. 4).

This is a very misleading way of putting as it could suggest that if banks receive total new deposits of $10 million they can immediately proceed to make loans of four times this. This is not so, and not really what the booklet meant to suggest. What it means is that the banks can immediately lend out only four-fifths of $10 million, or $8 million, and that this circulates throughout the banking system leading in theory to new loans totalling in the end $40 million, bringing total “bank deposits” up to $50 million.

Confusingly, the numerical examples the booklet goes on to give to illustrate this are based not on a 20 percent reserve fraction but on a 10 percent one (which is more or less what the law in the US requires for the kind of bank deposits in question). So, to take its example, if $10,000 is deposited in the banking system, initially say in one bank, that bank can make loans (create credit line bank deposits) of $9000. When it is spent this $9000 will be re-deposited in other banks which can then lend out 90 percent of this, or $8100; which in turn will be re-deposited in banks, allowing a further $7290 to be lent out, and so on, until in the end and over the period, a total of $90,000 new loans will have been made.

This shows how the Fed can practise “fractional reserve banking” to control the amount of “money” (currency plus bank deposits) in the economy. This is done via “open market operations” as explained in a section headed “Bank Deposits – How They Expand or Contract”:

“Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve its policy objectives . . . [T]he Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in US government securities. In today’s world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an ‘electronic’ check drawn on itself . . . The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances” (p. 6).

The bank from which the Treasury bills were purchased now has reserves above the 10 percent limit and so can turn the $10,000 into loans, which starts the process described above rolling, leading to an extra $90,000 bank lending.

In theory the Fed could contract bank lending in the same way, but this has never happened. So M1 has gone up and up each year. But what about the currency in all this? It too has gone up but passively and almost automatically. With increased banking activity more currency notes are required, which banks get by converting their reserves into this and which, if it hasn’t enough notes, the Fed just asks the Treasury to print more. But this has consequences -– the depreciation of the dollar and the rise in the general price level Congressman Paul doesn’t like.

But has the banking system really created more “money”? Only if you regard “bank deposits” as money. If you don’t, all that has been shown is that currency has circulated in that the whole process depends on the initial deposit or injection of cash being recycled as further deposits by depositors (as opposed to by banks creating a credit line). So, neither an individual bank nor the whole banking system can lend more than has been deposited with it. By the end of the process, in the example given, the first loan (out of the first deposit of $10,000) of $9000 has been used and used again for genuine deposits totalling $90,000. But all this assumes an expanding economy, since where is the money to repay the loans and the interest on them to come from without being assured of which the banks would not lend the money in the first place?

So the banking system does not create money to lend out of thin air but can only lend out money deposited with it and then only when economic conditions permit it.

Today, bank deposits are not the only source of what the banks lend. They also borrow on the money market (as has been highlighted by the present banking crisis). This means that their reserves are an even smaller percentage of their total loans, only about 3 percent in fact. This figure is mentioned in Zeitgeist Addendum as if this was now the “fractional reserve” and that therefore banks, or the banking system, can “create” loans of up to 33 times an initial deposit. Another silly mistake.

If currency cranks such as the makers of the Zeitgeist films have got the wrong end of the stick about “fractional reserve banking” and imagine that it means banks, whether singly or all together, can create money or credit out of thin air this is partly the fault of the way that booklets like the one produced by the Federal Reserve Bank of Chicago try to explain it. Of course the Fed does not believe the “thin air” claim, but to refute the currency cranks it would have not only to re-iterate that no single bank receiving an additional deposit of $10,000 can forthwith loan out $90,000, but also spell out that the expansion of credit line bank deposits still depends on people making real deposits of their own, unborrowed money (whether in cash or by cheque or by bank transfer). Which would restore a sense of reality and explode the myth that banks can create loans out of thin air.

Adam Buick