Sic Semper Tyrannis

In Frederick Soddy's 1926 tract "Wealth, Virtual Wealth and Debt" (a book I am currently working through), the Nobel laureate argues that the power of money/credit creation should be taken away from banks and placed in the hands of the state. He argued this because in his time, as in ours, most money and credit was in fact created by the banks -- not the government -- with the long-run result of significant inflation (punctuated here and there by deflationary panics, which are quite unpleasant). The mechanism of this runaway growth, then as now, was banks competitively issuing loans and other forms of securities utterly without limit or restraint.

Follow up:

One can expand this phenomenon to encompass all sorts of other money and money-like securities and to financial entities other than banks; the landscape today is truly breathtaking in its expanse and "creativity" -- witness businesses specializing in subprime mortgage lending, and the $370 trillion of derivatives in circulation measured as of the first half of 2006, just for starters.

Soddy argued the state should step in and clean house, by limiting money creation and allowing no more inflation than was needed to optimize production and prevent deflation and its concomitant industrial shocks (which, in turn, bring mass unemployment, which is obviously bad thing for a nation). Soddy proposed using two means of control in this system (neither of which he invented): (1) the reserve requirement, a ratio rule limiting the creation of bank credit by tying it to some multiple of liquid reserves held on deposit (not loaned out), and (2) a price level index to determine how much inflation is present in the economy. With these two tools, the national government could set the reserve ratio according to the measured price level, so that an increasing price level would necessitate a correspondingly-higher reserve ratio, hence making it a "governor" of the system (the apt analogy here is the economy to an engine).

This might sound something like the of system in place in the US today, with its Federal Reserve system playing the role of the "central bank". Unfortunately, while the Fed would like you to believe that is true, there are some key differences that totally undermine Soddy's programme and any sort of working restraint. The first is that we don't use the reserve fraction, almost at all, in the Fed system (the last vestiges were essentially eliminated in the early 90s). Instead, the Fed tries to control money/credit creation by "setting" interest rates (intervening in the bond market). In effect, this is an attempt to control the speed of the economy by setting only the price of money, rather than the quantity (even though setting the quantity would naturally lead to appropriate market interest rates).

But there is a second important difference between Soddy's proposed system and the one we have today: we do not have truthful measuring and reporting of the price level. Libertarian-minded readers of this blog probably heard some sort of little voice scream out in protest in the first paragraph where I wrote "placed in the hands of the state". That little voice was saying: "but won't the state also abuse this power, as an inevitable result of political forces?" The answer, as recent history has shown, is "yes".

In rest of this post, I will focus on the price level-measuring aspect of controlling inflation and the speed of the economy, putting aside the more fundamental but perhaps more contentious aspect of how the price level is translated into control of the growth of the money supply. I will show how getting the price level wrong (intentions aside) is not a benign fib; rather, it completely and terminally undermines any economy being run on a basis of structural inflation.

As Soddy said, the price level index should be used as the "governor" of the economy: when it rises quickly, money and credit growth should be decreased. The inverse of this rule also holds.

What Soddy didn't account for was the possibility that those reporting the price index level would lie about it. If they did, I propose this would lead to a "dynamic acceleration," where credit (debt) piles on exponentially in excess of productivity growth, creating a situation irreversible without depression or stagflation (deflation or severe inflation).

In the current economic practice and orthodoxy, productivity is the closest thing we have to a measure of "wealth." The important thing to note about productivity for our purposes is that it maps directly to the ability of society to service debt with future income streams. If society becomes more efficient, its income streams grow, and increasing debt can be paid off.

The "point of no return" is when real productivity growth can no longer cover increasing debt income streams. A critical word in that sentence is "real": this refers to productivity growth adjusted for the actual amount of inflation. Thus, in any system following Soddy's price-level governor, if inflation was to be underreported or productivity growth overreported, this debt overrun point would eventually be reached.

We can illustrate this numerically.

If money/credit growth is running at 2% per year, and productivity is growing at 5%, then we have a 3% productivity "surplus" which can go towards servicing additional debt burden. This surplus will, left alone, manifest as a 3% downward force on prices (deflation). Thus, to avoid deflation (if such a thing is desired), the money supply should be expanded faster -- precisely, at 5% per year, until inflation also increases at this rate and we reach equilibrium (the price level stops falling).

Similarly, if the price level is honestly reported, and would be rising at 2% per year with 0% productivity growth, increasing productivity to 2% per year would presumably introduce dynamic equilibrium: inflation would remain 2% per year but price levels would stabilize.

However if real inflation is 5%, with productivity at 2%, then we have a productivity "shortfall" of 3% which is not available to pay down an expanding debt burden. Normally this would be visible as a price level continuing to increase at a rate equivalent to that that 3% shortfall. But what if inflation was being underreported by that same 3% (intentionally or otherwise)?

Now we're in trouble: the price level will appear to be stable, so we think we've counteracted all incipient inflation with an equal amount of productivity growth, but we haven't. The 3% shortfall "builds up" as a corresponding increase in debt burden and demand on income streams every year. At this rate, in about 25 years, this burden will reach a level of about twice what the economy could actually handle (at equilibrium), which means the threat of a sudden, 50% deflation looms.

Unfortunately, I think the final scenario is roughly the situation the United States finds itself in today; having altered its inflation reporting beginning in 1983 and continuing to dubiously tweak the CPI metric throughout the 90s. The outcome is that inflation is underreported, probably by at least 2.5% per year, which suggests that in the 23 years since 1983 we've exceeded the economy's debt carrying capacity by at least 76%. This means a ~43% deflation is possible (for starters).

In fact, the extent of inflation under-reporting in the US is probably much greater, as the economy shifted to become more financing-based in the 90s, which introduced many sorts of "quasi-financial assets" to a greater extent than before. These assets aren't well-representated in the prevailing inflation measurements. For example, cars, housing and education became more common through financing, but also more expensive. Further, in the early 80s, the government shifted to the structural and ongoing use of bond issuance as an alternative to "printing money", mirroring the consumer's increased use of financing. The resulting growth of the national debt burden relative to the GDP is a measurement of the national productivity shortfall of the whole United States. This can be added to the "productivity overrun" created by the false inflation metrics.

This all surfaces as exponential growth in credit and debt in all echelons of the economy; the $10-11 trillion in public debt, the $13 trillion of consumer credit debt, the $20 trillion in mortgages, the $370 trillion of derivatives, the historically-inflated level of stocks, and so on.

To conclude, Soddy recognized the problem -- runaway money and credit creation -- but his proposed solution has utterly failed in practice in the United States. Sadly, our government has proven itself incapable of the necessary restraint to prudently manage the core of the economy: money. Whether through intellectual error, delusion or malice, the government has significantly mis-measured and mis-reported inflation over the past quarter-century. This has done no less than completely fail to meet the criteria laid down by Soddy and others to grow an inflationary economy soundly and sustainably.

What we have got as a result is the exact opposite of "sound and sustainable", and the worst consequences of this are yet to come.