Monday, 4 November 2013

The Madness of Generating Asset- and Price Inflation, and Why It's Rational for Some

Today, fellow Norwegian blogger The Boom Bust tweeted something highly relevant. Indeed, it is a true sign of our times,
To which I replied,

Yes, it's madness. But to be more specific, it's madness by government leaders and the voters whom accept it. As for the bankers, the inflationary policies are as rational as they can be, simply because they profit from them.

The whole issue can be traced back to fractional reserve banking backed by central banks (read: tax payers). The banking system wants to generate price- and asset inflation, or to be more specific, it can't survive, or at least not maximise profits, without it. For example, increasing house prices leads to increased home equity, which means households can borrow more, or more importantly, the banks can expand their lending business and their balance sheets and hence increase their profits further. House price deflation, on the other hand, will eventually lead to home equity turning negative for households, making it difficult, or downright impossible for banks, to issue further loans. Also, house price deflation could even lead to banks having to write down their loans (which is an asset for banks), easily wiping out the little equity banks generally have (e.g. 6.7% of total assets in Norway as of August and 10.94% for US commercial banks as of 23 October). Bank liabilities (deposits etc) remain unchanged. Through borrowing short term and lending long term, banks find themselves in a real squeeze if and when asset values fall.

This helps explain why central banks and the banking system as a whole is so keen on house price inflation. It's not without reason the Federal Reserve is buying mortgage-backed agency securities at a rate of USD 40 billion, every month! And it's not a surprise the banking system encourages borrowing through artificially low interest rates when times are bad: it thrives on issuing credit unbacked by a commensurate amount of prior savings - creating fiat money ex nihilo (out of nothing), and as a result expanding its balance sheets and profits (and executive compensation!). As for society as a whole (excluding banking), nothing is gained from increasing house prices induced by credit expansion (and other artificial stimuli) as increased profits for sellers are offset by an equal increase in the costs for the buyers (ceteris paribus). If increased house prices actually created real wealth, we could all simply agree to swap houses at prices above current market values. Would that make us all better off? Of course not. Increasing house prices can also be outright damaging for a society when it is driven by artificially low interest rates and aggressive credit growth (not backed by savings), thus creating bubbles enriching the astute and the savvy, but making life miserable for most hard working families (who ended up living beyond their means). The recent US housing bubble serves as a painful reminder of this potential damage such a bubble can bring about.

The economic issue that needs to be solved is therefore fractional reserve banking, a system which allows banks to create money out of nothing, backed by a central bank as the lender of last resort. Until this is changed to for example a system with a 100% reserve ratio for banks with no access to a central bank as the lender of last resort, central banks and banks in general will continue to generate price inflation the best they can. And they will be successful in doing so, because they are damn good at it - it is what they do for a living. Oh, almost forgot, and because they have a monopoly on the money printing press, a reason most markets have a significant element of socialism to it. And governments packed with politicians whose prime objective is to be reelected (instead of taking prudent care of the economy long term) will continue to rely on their co-dancers, the banking system, to finance their unrealistic election promises which can only be financed through debt increases and price inflation - the banking system has a monopoly on issuing fiat money granted by the very government they help finance. A convenient symbiosis to the detriment of many.

In the end the imaginary party is paid for by the general public through diminished purchasing power of their respective currencies and unnecessary economic cycles making it more than challenging to plan for the future. It is madness indeed, utter madness, and a giant step back for mankind.

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