Confidence Is Leaving the Fiat Money System

by Thorsten Polleit

Were it not for ever-greater increases in central-bank money and the market expectation that governments are about to make taxpayers shoulder commercial banks' huge losses, the fiat money systems would presumably collapse right away.

International interbank short-term lending rates say it all: the latest drastic increases in yield spreads between money-market rates and official central-bank rates are indicative of the growing reluctance among banks to extend loans to each other, for fear that borrowers could default on their payment obligations (see graph below).

Under today's fiat-money regime, banks, under governments' auspices, increase the money stock "out of thin air" whenever they extend loans. The money supply is built on credit, which, in turn, hinges on peoples' confidence in banks and banks' confidence in their borrowers' ability and willingness to service their debt.

As confidence leaves the system, banks refrain from extending loans and demand repayment of outstanding loans, and the money stock contracts. Economies that have for decades been fuelled by ever-higher doses of credit and money fall into depression — that is, declining production, employment, and prices.

Where the Losses Come From

To better understand the drop in confidence in the paper-money system, one should take a look at the issue of banks' accounting losses and payment losses. Assume, for instance, a bank buys a corporate bond for, say, US$100 and records it in its balance sheet.

If the bond price declines to, say, US$50 (due to rising market yields), the bank would have to make a write-down. The resulting US$50 loss would, via the profit-and-loss account, reduce the bank's recorded equity capital.

As long as the issuer of the bond continues to service his debt, however, the bank would recover its investment over the time. The accounting loss would not diminish the banks' capacity to pay its obligations vis-à-vis its own depositors and creditors.

If, however, the market price of the bond declines because its issuer no longer pays, the banks' incoming cash flows would be lower than hitherto expected, resulting in a payment loss — and this could, if payment losses are large, make the bank default on its obligations.

The Issue of a Loss of Confidence

An accounting loss can easily develop into a payment loss. This is because bad news about banks' financial health (profit warning) can trigger a loss of confidence. Such a market reaction is rational, given the system of fractional-reserve banking.

Under fractional-reserve banking, banks keep just a fraction of their immediate payment obligations (basically sight deposits) in the form of cash. As a consequence, they cannot meet all their payment obligations should customers whish to withdraw their sight deposits all at once.

However, banks enjoy a privilege granted by the government. Central banks, the holders of the money supply monopoly, can provide banks with whatever amount of cash is needed. With central banks acting as lender of last resort, the chances for a bank run, initiated by private savers, have been greatly reduced.

What spells trouble, however, is an institutional bank run: banks lose confidence in each other. Most banks rely heavily on interbank refinancing. And if interbank lending dries up, banks find it increasingly difficult, if not impossible, to obtain refinancing (at an acceptable level of interest rates).

Maturity Transformation and Credit Derivatives

An institutional bank run is particularly painful for banks involved in maturity transformation. Most banks borrow funds with short- and medium-term maturities and invest them longer-term. As short- and medium-term interest rates are typically lower than longer-term yields, maturity transformation is a profitable.

However, in such a business, banks are exposed to rollover risk. If short- and medium-term interest rates rise relative to (fixed) longer-term yields, maturity transformation leads to losses — and in the extreme case, banks can go bankrupt if they fail to obtain refinancing funds for liabilities falling due.

Growing investor concern about rollover risks has the potential to make a bank default on its payment obligations: interest rates for bank refinancing go up, so that loans falling due would have to be refinanced at (considerably) higher interest rates. The latest price action clearly suggests that banks active in maturity transformation could be up for quite some trouble (see graphs below).

In an environment of rapidly declining confidence in the banking system, investor concerns about derivative instruments, credit derivatives in particular, may well accelerate the very forces that disintegrate the fiat-money regime.

To be sure, there is nothing wrong with credit derivatives as such. Credit derivatives are instruments that help to value, trade, and reallocate existing risks among market participants, thereby making the financial system more efficient.

However, the outstanding expansion of credit derivatives, heaped upon a gigantic paper-credit pyramid, has been stimulated to a great extent by central banks' chronic low interest rates, having made investors search for yield pick-up and ignore credit and market risks.

There is little experience with how the financial positions of market participants would be affected in the case of major players going bankrupt. The extraordinary size and complexity of the credit-derivative market could pose a substantial unwinding challenge in the event of the exit of several major counterparties.

Closing out and replacing positions could lead to drastic changes in underlying financial-asset prices. As investors cannot be sure that all market participants could weather the consequences of a default in the underlying credits or the effects of a prolonged disruption to market liquidity, confidence in the solidity of the monetary order may drop even faster in times of market stress.

Postponing the Ultimate Disaster

The issues outlined above are symptoms of the crumbling monetary (dis)order. Their underlying causes are to be found in the government-sponsored expansion of bank credit and money. It is a system that stretches the monetary demand beyond the economies' economic resources.

By artificially lowering the interest rate through credit expansion, central banks induce inflation-induced boom-and-bust-cycles, which lead to unsustainable debt levels. In all western countries overall debt levels as a percent of GDP have gone up strongly in recent decades.

Whenever financial markets set out to end the disastrous process through, for instance, a decline in economic activity, governments and their central banks will do whatever it takes to keep the fiat-money system going: lowering interest rates by increasing credit expansion and increasing the money supply.

In the current situation, however, banks' capacity to keep expanding the credit and money supply has been greatly diminished: accounting losses and — due to waning confidence in the system — presumably also payment losses erode banks' equity capital further in the time to come.

With their far-reaching coercive power, however, governments may, at least temporarily, be in a position to prevent an imminent implosion of the credit and money system. Governments can decide to redistribute peoples' incomes on the grandest scale: shoring up banks' eroding equity capital or guaranteeing financial institutions' assets or liabilities, or nationalizing the banking/finance industry.

At a more technical level, central banks can be made to refinance banks directly, thereby replacing the interbank markets altogether. In such a regime, central banks would presumably not only fix the short-term (overnight) interest rate but medium- to longer-term interest rates as well.

Alternatively, central banks can prop up banks' capital base by taking over their loss-making assets — a procedure already adopted by the US Federal Reserve and by other central banks, as they have also started accepting securities of questionable value in their open-market operations.

When central banks form an international cartel — with the purpose of preserving the fiat-money system — domestic banks wouldn't default, even if their payment obligations are denominated in foreign currency (which the national central bank cannot produce): central banks would simply lend money to each other.

Abandoning the Path Towards Inflation

By increasing the base money supply in the interbank market, guaranteeing financial institutions' liabilities or nationalizing the banking industry, governments suppress free-market forces, which could move the system back towards equilibrium.

There should be little doubt that, after decades of government sponsored credit and money-supply expansion, such a correction would be economically painful, accompanied by further bank failures and output and employment losses.

However, it is hard to see how fighting the symptoms of the unfolding monetary fiasco could solve its underlying cause. Starting the printing presses wouldn't solve the debt crisis either. Hyperinflation would cause economic and political damage to the greatest possible extent.

To qualify as a remedy to present ills, government action needs to be constrained to a far-reaching reform of the monetary systems, which, if implemented properly, would neither cause deflation nor inflation.[1] Markets need to be liberalized to the greatest extent to allow prices to adjust back to equilibrium.

A return to sound money is needed. This would, as outlined by many Austrian economists, require putting an end to government's monopoly over monetary affairs. The power for determining the quantity and quality of money must be returned to free-market forces. Money in the hands of the government and its central bank would sooner or later become the ruin of the free societal order.

As Ludwig von Mises noted,

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.[2]

The credit crunch

Saving the system

At last a glimmer of hope, but more boldness is needed to avert a global economic catastrophe

CONFIDENCE is everything in finance. Until this week the politicians trying to tackle the credit crunch had done little to restore this essential ingredient. In America Congress dithered over the Bush administration’s $700 billion bail-out plan. In Europe governments have casually played beggar-my-neighbour politics, with countries launching deposit-guarantee schemes that destabilise banks elsewhere. This week, however, saw the first glimmers of a comprehensive global answer to the confidence gap.

One clear sign was an unprecedented co-ordinated interest-rate cut on October 8th by the world’s main central banks, including the Federal Reserve, the European Central Bank, the Bank of England and (officially a coincidence) the People’s Bank of China. Various continental European countries also set about recapitalising their banks. But the most astounding developments were in America and Britain. The Fed doubled the amount of money available to banks on a short-term basis to $900 billion and announced that it would buy unsecured commercial paper directly from corporate borrowers. More surprisingly, Gordon Brown’s government, hitherto the ditherer par excellence, produced the first systemic plan for dealing with the crisis, not just providing capital and short-term loans to banks but also offering to guarantee new debt for up to three years (see article).

This is certainly progress, but it is not enough (see our extended finance section). The world’s finance ministers and central bankers, gathering in Washington, DC, this weekend for the annual meetings of the IMF and World Bank, should deliver a simple message: more will be done. The world economy is plainly in a poor state, but it could get a lot worse. This is a time to put dogma and politics to one side and concentrate on pragmatic answers. That means more government intervention and co-operation in the short term than taxpayers, politicians or indeed free-market newspapers would normally like.

The patient writhing on the floor

If the panic that has choked the arteries of credit across the globe is not calmed soon, the danger will increase that output in rich economies will not simply shrink, but collapse. The same could happen in many emerging markets, especially those that rely on foreign capital. No country or industry would be spared from the equivalent of a global financial heart attack.

Stockmarkets are in a funk. But the main problem remains the credit markets. In the interbank market the prices banks pay to borrow money from each other are still near record highs. Meanwhile corporate borrowers have found it hard to issue commercial paper, as money-market funds have fled from all but the safest assets. In emerging markets bond spreads have soared and local currencies plunged. And whole countries have begun to get into trouble. The government of Iceland has had to nationalise two of its biggest banks and is frantically seeking a lifeline loan from Russia. Robert Zoellick, president of the World Bank, says there could be balance-of-payments problems in up to 30 developing countries.

The damage to the real economy is becoming apparent. In America consumer credit is now shrinking, and around 159,000 Americans lost their jobs in September, the most since 2003. Some industries are hurting badly: car sales are at their lowest level in 16 years as would-be buyers are unable to get credit. General Motors has temporarily shut some of its factories in Europe. Across the globe forward-looking indicators, such as surveys of purchasing managers, are horribly gloomy.

If the odds of a rich-world recession have risen towards a near certainty, the emerging world as a whole is slowing rather than slumping. China still seems fairly resilient. Taken as a whole, though, growth in the world economy seems likely to slow below 3% next year—a pace that many count as recessionary. So the prospects are grim enough, but a continuing credit drought would make this much worse.

Lessons old and new

The lesson of history is that early, decisive government action can stem the pain and cost of banking crises. In the 1990s Sweden moved to recapitalise its banks quickly and recovered quickly; in Japan, where regulators failed to tackle toxic debt, the slump lasted for most of the decade. The twist is that this credit crisis is deeper (it affects many more types of markets) and broader (many more countries). Any solution has to be both more systemic and more global than before. One country trying to mend one part of its banking system will not work.

The idea of a comprehensive solution sounds simple, if expensive. But politicians have found it hard to grasp. Europeans have remained stubbornly wedded to the notion that the mess was “Made in America”; John McCain and Barack Obama talk as if it was all down to the greed of modern bankers. But financial excesses existed centuries before a brick had been laid on Wall Street. As our special report this week lays out, today’s bust—and the bubble that preceded it—had several causes besides dodgy lending, including a tide of cheap money from emerging economies, outdated regulation, government distortions and poor supervision. Many of these failures were as evident outside America as within it.

With a flawed diagnosis of the causes of the crisis, it is hardly surprising that many policymakers have failed to understand its progression. Today’s failure of confidence is based on three related issues: the solvency of banks, their ability to fund themselves in illiquid markets and the health of the real economy. The bursting of the housing bubble has led to hefty credit losses: most Western financial institutions are short of capital and some are insolvent. But liquidity is a more urgent problem. America’s decision last month to let Lehman Brothers fail—and the losses that implied to money-market funds that held its debt—prompted a global run on wholesale credit markets. It has become hard for banks, even healthy ones, to find finance; large companies with healthy cash flows have also been cut off from all but the shortest-term financing. That has increased worries about the real economy, which itself adds to the worries about banks’ solvency.

This analysis suggests that governments must attack all three concerns at once. The priority, in terms of stemming the panic, is to unblock clogged credit markets. In most cases that means using central banks as an alternative source of short-term cash. This week the Fed took another step in that direction: by buying commercial paper, it is now in effect lending direct to companies. The British approach is equally bold. Alongside the Bank of England’s provision of short-term cash, the Treasury says it will sell guarantees for as much as £250 billion ($430 billion) of new short-term and medium-term debts issued by the banks. That is risky: if left for any length of time, those pledges give banks an incentive to behave recklessly. But a temporary guarantee system offers the best chance of stemming the panic, and if it were internationally co-ordinated it would be both more credible and less risky than a collection of disparate national promises.

The second prong of a crisis-resolution strategy must aim to boost banks’ capital. A new IMF report suggests Western banks need some $675 billion of new equity to prevent banks from rapidly reducing the number of loans on their books and hurting the real economy. Although there is plenty of private capital sloshing around, there is a chicken-and-egg problem: nobody wants to buy equity in an industry without enough capital. It is becoming abundantly clear that government funds—or at least government intervention—will be necessary to catalyse the rebuilding of banks’ balance sheets. Initially, America focused more on buying tainted assets from banks; now it seems keener on the “European” approach of injecting capital into their banks. Some degree of divergence is inevitable, but more co-ordination is needed.

Third, policymakers should act together to cushion the economic fallout. Now that commodity prices have plunged, the inflation risk has dramatically receded across the rich world. With asset prices plummeting and economies shrinking, deflation will soon be a bigger worry. The interest-rate cuts are an important start. Ideally, policymakers would not use only monetary policy. For instance, China could do a lot to help the rest of the world economy (and itself) by loosening fiscal policy and allowing its currency to appreciate more quickly.

A long wait

Even in the best of circumstances, the consequences of the biggest asset and credit bubble in history will linger. But if the panic is stemmed, it could be a manageable problem, cushioned by the economic strength in the emerging world. Efforts at international economic co-operation have a patchy record. In the 1980s the Plaza and Louvre accords, designed respectively to push the dollar down and to prop it up, met with mixed success. Today’s problems are deeper and more countries are involved. But the stakes are also much higher.

The markets

Off a cliff

Markets in America, Asia and Europe plummet, as fears grow over financial and economic conditions

MARKETS in Asia and Europe plummeted on Friday October 10th. Japan’s stockmarket ended the week in disarray: the Nikkei 225-share index fell by 24% on the week, twice the weekly fall of the 1987 crash. It is now at five-and-a-half-year lows. Europe followed suit. London’s FTSE 100 slumped by more than 10% within minutes of opening; by mid-morning European stocks were also down, with Germany's DAX index down by more than 8%. Amid widespread anxiety the oil price also tumbled, to around $81 a barrel, its lowest level in a year.

The falls underline that stockmarkets, traumatised by the near-paralysis in credit markets, the collapse of once-mighty banks and the prospect of global recession, are suffering what has been dubbed a “cascading crash”: a series of blows which, added together, are stomach-churning.

Wall Street is unimpressed by the TARP, America’s much-vaunted $700-billion bail-out. The Dow Jones Industrial Average had plunged by 679 points, or 7.3% on Thursday. Nor are markets reassured by a bevy of bank rescues, a co-ordinated rate cut by the world’s leading central banks, the Federal Reserve’s radical decision to buy commercial paper, Britain’s £500 billion ($861 billion) bail-out package, nor the raft of piecemeal rescues by other European governments. On Thursday the International Monetary Fund activated a procedure to offer emergency loans to threatened countries, such as Iceland, which took over its largest bank on Thursday.

In Asia, which had been relatively insulated from recent woes, panic selling set in, as markets slumped in Hong Kong, South Korea and Taiwan, among others. Indonesia's fell by 10.4% on Wednesday before regulators suspended trading. (Equity trading was also suspended in several European exchanges, including those of Russia, Austria and Iceland.)

At the start of this latest phase of the credit crisis, Japan's financial markets had seemed to float over the top of the global turmoil. Lehman Brothers' collapse, admittedly, had shut off the samurai market used by overseas companies to issue yen-dominated bonds, while overseas banks had trouble getting overnight funds until the Bank of Japan stepped in with assurances. Otherwise Japan's financial markets had functioned pretty smoothly, with well-capitalised banks lending freely to each other and, in the case of Mitsubishi UFJ, one of the big three, snapping up the apparent bargain of a 21% stake in Morgan Stanley for $9 billion. (Morgan Stanley's shares tumbled by 25% on Thursday as investors once again bet that its days as an independent firm are numbered.)

Now all hope that Japan might remain aloof is gone. Overseas hedge funds have been panic sellers of shares. Even cast-iron Japanese government bonds are being shunned in favour of cash—leaving questions about how the government is to refinance a lot of debt coming due over the next month or more. On Friday Yamato Life, a medium-sized insurer, filed for bankruptcy, the first Japanese life insurer to go under in seven years.

In America the scale of the fall is dramatic. A year ago the Dow, resilient in the face of what then seemed only a subprime-mortgage crisis, hit an all-time high of a whisker over 14,000. It is now some 40% lower, having fallen double the distance that signals a bear market. In the past seven trading days alone it has lost 21% of its value.

There is a good deal of bewilderment, as well as fear. Many had assumed that the strenuous, if belated, actions by governments to restore confidence in debt markets would bring a semblance of calm. But these efforts have so far done little to convince markets that the worst is over.

Private-sector predictions of the pain to come are getting darker by the day: Weiss Research reckons that more than 1,600 American banks and thrifts, with $3.2 trillion of assets, are at risk. AIG, an American insurer that had already needed an $85 billion loan, has tapped the Federal Reserve for a further $38 billion to keep itself liquid. And cracks have appeared in the industry’s last remaining pillars of strength as it becomes clear that big losses are coming in consumer and corporate credit as well as mortgages. There were signs on Thursday that confidence was ebbing in another relatively unscathed American titan, Wells Fargo, whose shares finished down by some 15%.

Not only are buyers of stocks conspicuously absent, but much of the selling is forced. All agree that there will be no meaningful recovery until the credit markets are unclogged. The rates at which banks lend to each other are still at or near records. The rate at which companies can borrow over short periods is starting to fall, but only slightly. Longer-term borrowing markets are still mostly shut.

Fixing credit markets could prevent a depression, but a nasty recession looks all but guaranteed. Among those expected to be most affected are retailers, who have been slashing profit forecasts, and the already beleaguered carmakers. The latter have used customer-finance to prop up sales in recent years. General Motors’ shares went into free-fall on Thursday, dropping 31% after a rating agency threatened to downgrade its debt. The once mighty firm now has a market capitalisation of just $2.7 billion.

Finance ministers of the group of seven rich countries are set to meet in Washington, DC, on Friday. The rest of the world’s finance ministers and central bankers join them this weekend for the annual meetings of the IMF and World Bank. As the damage to the real economy is becoming apparent, the challenge is to come up with a comprehensive, co-ordinated intervention that might just begin to restore confidence.

Cost of U.S. Crisis Action Grows, Along With Debt (Update1)

Oct. 10 (Bloomberg) -- The global financial crisis is turning into a bigger drain on the U.S. federal budget than experts estimated two weeks ago, ballooning the deficit toward $2 trillion.

Bailouts of American International Group, Fannie Mae and Freddie Mac likely will be more expensive than expected. States are turning to Washington for fiscal help. The Federal Reserve said this week it will begin buying commercial paper, the short- term loans companies used to conduct day-to-day business, further increasing costs. And analysts now say the $700 billion bank- rescue plan passed by Congress last week may have to be significantly larger.

``I always assumed they would be asking for more money along the way if it was necessary, and it looks like it's going to be necessary,'' said Stan Collender, a former analyst for the House and Senate budget committees, now at Qorvis Communications in Washington. ``At the moment, there's nothing happening here that's positive for the budget. Nothing.''

The 2009 budget deficit could be close to $2 trillion, or 12.5 percent of gross domestic product, more than twice the record of 6 percent set in 1983, according to David Greenlaw, Morgan Stanley's chief economist. Two weeks ago, budget analysts said the measures might push deficit to as much as $1.5 trillion.

Yields to Rise

That means a lot more borrowing by Treasury, which will push up interest rates, said Greenlaw. ``The Treasury's going to be ramping up supply dramatically over the course of coming months to meet this enormous federal budget obligation,'' Greenlaw told Bloomberg this week. ``The supply will trigger some elevation in yields.''

Treasuries have fallen the past four days even as stocks sank, a sign investors are preparing for bigger U.S. government borrowing. Benchmark 10-year note yields rose to 3.82 percent at 7:49 a.m. in New York, from a close of 3.45 percent Oct. 6.

Payments the government allocated to keep vital companies solvent are beginning to look insufficient.

AIG, the giant insurance company that was taken over by the government in mid-September, said this week it may access $37.8 billion from the Federal Reserve Bank of New York, in addition to the $85 billion the government already loaned it to stave off bankruptcy.

``You're in for a dime, you're in for a dollar on this one,'' said David Havens, a credit analyst at UBS AG.

The financial health and earnings prospects of Fannie Mae and Freddie Mac -- seized by the government on Sept. 7 to prevent them from failing -- worsened in the second and third quarters, the companies' government regulator said this week.

Price Declines

The companies and regulators are recalculating the value of all of their assets to factor in price erosion. That may mean the government will have to spend more to keep the firms solvent.

Earlier this week the Fed announced it will create a special fund to buy commercial paper, the credit that businesses use to finance payrolls and other ongoing expenses. The Treasury will deposit money into the Fed's New York district bank to help set up the new unit. A Fed official said Treasury funding for the program could be ``substantial.''

California, Alabama and Massachusetts are urging the Fed and Treasury to include their securities in rescue plans designed for banks and businesses. The $2.66 trillion U.S. market for state and city bonds has been all but frozen since Lehman Brothers Holdings Inc., weighed down by losses in mortgage-backed bonds, declared history's largest bankruptcy on Sept. 15.

California has said it needs to sell as much as $7 billion in notes to maintain its schools, health system and other public services. The Bush administration said it is reviewing the states' financial positions.

Plan for Banks

Meanwhile, Treasury Secretary Henry Paulson indicated two days ago that he is considering buying stakes in a wide range of banks in coming weeks to help recapitalize them.

Such a move is allowed under the $700 billion bailout package Congress passed last week. Edmund Phelps, winner of the 2006 Nobel Prize for economics and a professor at Columbia University, said such action is necessary -- and will likely turn out to increase the measure's cost. Spending beyond the amount set in last week's bill would require further Congressional approval.

``We have to recapitalize the banks,'' Phelps told Bloomberg Television this week. ``I don't imagine that there's enough money in the first Paulson plan to be able to do all that needs to be done in that direction.''

The additional borrowing could push the national debt well past 70 percent of GDP, the highest since the immediate aftermath of World War II, when the U.S. was still paying off war debt.

Debt Limit

Gross U.S. debt, which includes debt held by the public and by government agencies, this year reached about $9.6 trillion, or about 68 percent of gross domestic product. The rescue legislation increased the government's debt limit to more than $11.3 trillion from $10.6 trillion.

On top of all that, budget watchdogs say the sheer size of the interventions is making Washington more profligate than usual. To attract votes in Congress, leaders added several costly items to the $700 billion rescue, including extensions of some tax credits and tax breaks for makers of wooden arrows and stock- car racetrack owners.

Under normal circumstances, there would have been more resistance to such expenses, said Robert Bixby, executive director of the Concord Coalition, a non-partisan budget watchdog.

The rescue legislation ``creates a mask for all sorts of fiscal irresponsibility,'' said Bixby. ``It covers up a multitude of sins.''