LESSONS FROM THE JAPANESE:
TIME TO REPLACE SOVEREIGN DEBT WITH SOVEREIGN CREDIT

“We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon.”

Robert H. Hemphill, Credit Manager of the Federal Reserve Bank of Atlanta, 1934

Miners used to keep canaries in coal mines as an early warning device. If the air was so bad that it killed the canary, the miners would soon be next. Japan may be the canary for the out-of-control deficit spending policies now being pursued in the United States and the United Kingdom. In a November 1 article in the Daily Telegraph called “It Is Japan We Should Be Worrying About, Not America,” international business editor Ambrose Evans-Pritchard wrote:

“Japan is drifting helplessly towards a dramatic fiscal crisis. For 20 years the world’s second-largest economy has been . . . feeding its addiction to Keynesian deficit spending – and allowing it to push public debt beyond the point of no return. The rocketing cost of insuring against the bankruptcy of the Japanese state is telling us that the model has smashed into the buffers.

“. . . Tokyo’s price index fell 2.4% in October, the deepest deflation in modern Japanese history. . . . The government could stop this . . . . It could print money à l’outrance to stave off deflation. Yet it sits frozen, like a rabbit in the headlamps.

“Japan’s terrible errors are by now well known. . . . QE was too little, too late, and this is the lesson for the West. We must cut borrowing drastically over the next decade, and offset this with ultra-easy monetary policy. Does Downing Street understand this? Does the White House? . . . Clearly not.”

In case you too have forgotten your high school French, “a l’outrance” means “to the uttermost.”  “QE” is “quantitative easing” – printing money. Evans-Pritchard’s proposed solution to the mounting fiscal crisis is that the government needs to quit borrowing money and start printing it.    

More Funny Money? Please!

Your response is liable to be that the government is doing that already, in spades; and it does not seem to be working. The Federal Reserve is madly printing money (or writing it into electronic accounts), increasing the money supply to the point that worried pundits are screaming about hyperinflation. Yet the credit crunch just continues to get worse.

And that is true. Money is being printed; but it is not being printed by the government. The U.S. government has opted to borrow rather than print, just as the Japanese did. The Federal Reserve is a privately-owned central bank, which issues Federal Reserve Notes (or dollars) and lends them to the government and to other banks. Those banks then leverage the money into many times that sum in interest-bearing loans. 

The problem today is that bank lending has fallen off dramatically. The Fed has been creating money as fast as it can find federal and bank borrowers to take the money off its hands, yet it can’t keep up with the rampant deflation in the real economy. Bank lending has dropped by 17 percent since October 2008, when the credit crisis was already in full swing. “There has been nothing like this in the USA since the 1930s,” says Professor Tim Congdon of International Monetary Research. “The rapid destruction of money balances is madness.”

The reason the level of bank lending is so important is that virtually all of our money today originates as loans created by private banks. Most people think money is issued by the government, but the only money the government creates are coins, which compose less than one ten-thousandth of the money supply – about $1 billion out of $13.8 trillion (M3). Coins and dollar bills together make up only about 7% of the money supply. All of the rest is simply written into accounts on computer screens by bankers when they make loans.

And this is the real source of the exponential inflation in the money supply in the last half-century. Contrary to popular belief, banks do not lend their own money or their depositors’ money. As the Federal Reserve Bank of Dallas> explains on its website:

"Banks actually create money when they lend it. Here's how it works: Most of a bank's loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank ... holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times."

As Robert Hemphill observed in the 1930s, if we had no banks we would have no money, other than pennies, nickels, dimes and quarters. When old loans are paid off and new ones aren’t taken out to replace them, the money supply shrinks; and lately, new loans have fallen off dramatically.

Why? Banks insist that they are lending as much as they are prudently allowed to. The problem is that they have reached the lending limits imposed by the capital requirements set by the Bank for International Settlements. In the years of the credit boom, banks were able to leverage their capital into far more loans than are being created now. This was because loans were taken off the banks’ books by investors, allowing the same capital to be used many times over to generate new loans. These investors, called “shadow lenders,” have now exited the market, and they are not expected to return any time soon. They left after it became clear that the credit default swaps allegedly protecting their investments were only as good as the solvency of the counterparties (typically AIG or hedge funds), which had a bad habit of going bankrupt rather than paying up. An estimated $10 trillion disappeared from the money supply along with the shadow lenders, and the Fed has managed to get only a few trillion back into the market as replacement money.

“Shadow Money”: Another Blow to the Quantity Theory of Money

Along with the disappearance of the “shadow lenders,” there has been a dramatic decline in something called “shadow money.” The concept of shadow money was presented by two economists from Credit Suisse, James Sweeney and Carl Lantz, in a Bloomberg interview in May. As explained on DemandSideBlog, shadow money is money the market itself creates in order to finance a boom -- “money” in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral is used as near money or shadow money. Shadow money can include government bonds, private bonds, asset-backed securities, credit card debt (which can be incurred and paid off without drawing on the M1 money stock), and even real estate (when it is highly liquid and easily tradeable).

In a fuller explanation on Zero Hedge, Tyler Durden (a pen name) quotes from Friedrich Hayek’s Prices and Production (1935). Hayek said:

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognized to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

“. . . [I]t is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.”

Lantz and Sweeney calculate that at the peak of the boom there were six trillion dollars in the traditionally-defined money stock (or money supply). The private shadow stock accounted for $9.5 trillion, and government-based shadow money accounted for another $11 trillion. Thus the shadow money stock dwarfed the traditionally-defined money stock. This can be seen in the chart below provided by Tyler Durden. The blue strips at the bottom, called “outside money,” are dollars printed by the Federal Reserve. The red sections, called “inside money,” are money created as loans by the banks themselves. The green sections, called “public shadow money,” are money created by the government and the Fed as debt (or loans). The purple sections, called “private shadow money,” are the money created as private debt securities by the shadow lenders. 

shadow money

Lantz and Sweeney estimate the total drop in private shadow money (the purple blocks) during the current credit crisis at $3.6 trillion. This has been offset by an increase in public shadow money, both from the massive borrowing needed to finance the federal deficit and from the aggressive liquidity measures taken by the Fed in converting private securities into loans.  Those measures helped prevent an even worse drop in the commercial money supply than actually occurred, but they were not sufficient to eliminate the credit squeeze from lowered commercial lending, which continues to act as a tourniquet on the productive economy.

Moreover, the lending situation is slated to get worse. At the G20 meeting in Pittsburgh in September, deadlines were set for increasing the amount of capital that financial institutions must set aside to cover their loans. That means that credit could get even tighter, further shrinking the global money supply and precipitating an even deeper depression.

How to Save $400 Billion Yearly in Interest: Monetize the Debt

Although the Federal Reserve cannot create money and simply spend it into the economy, Congress can. The Constitution authorizes Congress “to coin money [and] regulate the value thereof.” A former chairman of the House Coinage Subcommittee once observed that Congress could solve its debt problems just by minting some very large-denomination coins. This solution is invariably rejected as dangerously inflationary; but when the “shadow money” is factored in, we can see that it wouldn’t be. Government bonds already serve as money in the sense of a medium of exchange. They trade in massive quantities around the world just as if they were money. Paying off government bonds with newly-printed dollars and then ripping up the bonds (or voiding them out on a computer screen) would not significantly affect the size of the overall money supply, since “shadow money” would just be replaced with dollar bills (paper or electronic). In the chart above, green money (public shadow money) would become blue money (dollar bills and checkbook money), leaving the total money stock unchanged.

It might be argued that the money borrowed by the government has already been spent into the economy, and that if the bonds are now turned into dollars, the money will be out there twice. That is true; but on the shadow-money model, the inflation has already occurred and cannot now be reversed. It occurred when the government printed the bonds. The bonds are already out there serving as money. Whether the money stock takes the form of dollars or bonds, it will be used as a medium of exchange in the real economy.

Another argument often raised is that the money created as government securities and Federal Reserve loans has been “sterilized” by lodging it with central banks and commercial banks. When this money hits Main Street as dollars competing for goods and services, the floodgates will open and hyperinflation will be upon us. That is the alleged justification for keeping the stimulus money in the banks instead of in the marketplace. But then what was the point of the stimulus? If the money is only stimulating the banks, it is not doing anything for the real economy. We want money out there in the marketplace generating demand for products, which generates jobs. Price inflation results only when “demand” (money) exceeds “supply” (goods and services). If the money is used to create goods and services, prices will remain stable. We have workers out of work and factories sitting idle. They need some “demand” (money) stimulating them to create supply, in order to make the economy productive again.

Other critics point to gold’s recent rise as an indicator of dangerous inflation already being upon us. The more likely explanation for gold’s rise, however, is that foreign central banks are looking for something besides U.S. government bonds in which to park their money. They no longer want our bonds, so fine. Let’s tell them no more are for sale. We will in the future sell our bonds to our own central bank, which will rebate the interest to the government after deducting its costs . And we will use the money, not to feed a parasitic private banking empire by building up bank reserves, but for direct expenditures on infrastructure and other public projects that will put people back to work, add to the productive economy, and increase the collective well-being of the people.