Our Broken Financial System
Thursday, 1/30/2020 17:58
Why the young must escape the grasp of 'compliance'...
WHAT's gone wrong with our financial system, and how can we fix it?
asks Paul Tustain, founder and chairman of BullionVault.
Many younger people, who are so ill-served by the way the system works today, think it was some inherent wickedness in banks, free markets and capitalism which did the damage. It really wasn't.
The blame lies squarely with a deeply misguided government policy, adopted enthusiastically by both left and right.
My hope here is to guide a few bold millennials to pick up the tradition of the liberal philosopher and Nobel economist Friedrich Von Hayek, so that they can help to redirect their generation away from a depressing but avoidable journey; what Von Hayek called "The road to serfdom". It's the road we are all on.
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Author's note: The author wishes to to express that he does not doubt the good intentions of the people who work within organisations criticised here. Criticism is intended constructively, primarily to engage more people – especially the young – in a serious debate about how our financial system works. We all want to see it continue to benefit Britain and its people for the long term.]
What is a free society?
Wouldn't it be wonderful if a free society meant that we could all do exactly as we pleased?
Actually it wouldn't be that wonderful at all. Nobody would really value freedom if it worked like that, because our societies would rapidly fill up with people who were both selfish and idle.
A free society requires us to honour its two main principles:
- We must accept a general responsibility to pay our own way;
- Excepting fair competition we must not inflict harm on other people.
To be reasonably civilised we need to add a duty, to care for people who cannot manage the first, and we need laws and enforcement to formalise the implementation of the second. But allowing for those, that's it – and our laws do not need to ban everything which might cause harm.
Freedom permits risk. It allows harm caused indirectly as a consequence of something which a reasonably informed person consents to. Bad investments, sporting injuries, obesity, cigarette-induced cancer etc are all the indirect consequences of free people accepting risk, as is their absolute right.
The glory of freedom is that if we live by these two very reasonable principles, we can choose the details of how we live our lives, both serving and being served by our society in whichever ways suit us, and it.
A pleasing side effect of our liberty is that we'll enjoy widespread prosperity too. Any introduction to economics quickly explains that specialisation increases productivity – and doubly so when re-inforced by personal motivation. If each of us chooses what we do, guided both by what we enjoy and by the value that other members of society place on what we provide, then through trade and exchange everyone ends up with more, and our society becomes wealthier.
Freedom, specialisation and trade make comfortable partners, and the resulting dynamism and prosperity get generated on many levels, from individuals in pre-historic villages, to modern nation states.
What is money?
In every case we know of, freedom, specialisation and trade co-exist alongside a system of money, which is nothing more than a scorekeeping system for outstanding favours which have been generated through trade and exchange. (You can substitute 'credits' for 'outstanding favours' if you like your definitions concise.)
With this formal definition of money you can now see how some money exists in banks' scorekeeping systems – their ledgers – some in the form of electrons, in computerised scoring systems, some (once-upon-a-time) as rare sea-shells, and even some as coins and notes – portable tokens which work in the same way as counters, for keeping score in a child's game.
Payments systems are easier to understand once we understand that every form of money is a scorekeeping system. You can forget the conceptual difficulty of trying to work out how money is "sent down a wire", or "cleared" via a cheque, both of which are extremely difficult to make sense of if you think real money starts with notes and coins. All payments are just agreed ways of modifying two people's scores.
There's another very useful way to think of money. It's not a definition but it's helpfully descriptive. Money is our 'suspended opportunity to trade' – 'suspended' because we've not yet decided how to use the credits we have just generated in trade.
Money keeps things fair in a world where people trade with each other, and it has been repeatedly re-invented. Cuneiform, written on clay tablets, was among the earliest known human writing systems. Many examples show merchants using it for monetary scorekeeping. For thousands of years since, wherever there hasn't been a serviceable credit scorekeeping system in place, ordinary people have invented one, because they have found that the specialisation and trade which money enables has the beneficial effect of enriching them all.
But nowhere was money invented as a tool of government.
Where does modern money come from?
Most people think modern money comes from the central bank, acting as an agent of government. That's not how it works.
Government does have a role, but historically it did little more than define the unit of money. That kept all the users of money, in commerce, and across different banks, interoperable with each other. But historically government did not then create the money. That was done by businesses, and it's still the case.
By and large, the units of modern money, like Pounds and Dollars, are created in the scorekeeping records of ordinary banks' accounting systems, out of privately owned collateral property – things like houses and factories which are pledged by their owners against debt. The balancing entry – the credit – is money that can be spent.
Just about any marketable capital asset can be made into money in this way, which shows how money is not abstract (as so many people think) but is deeply linked to the stock of property in our society.
Here's a slightly old example of money being created by a small private bank:
Nowadays actual banknotes really do come into existence exclusively via the central bank, leaving most of us thinking that this is some immutable law about money in general. But as you can see from the picture it's not always true, either in history, or in theory.
In fact a modern central bank is a manifestation of the control government has taken over all of us and our money, and over our ability to use money as a tool of trade wherever we wish. A central bank runs a monetary monopoly on behalf of government, and in consequence it will tend to develop many of the problems that monopolies often have – like arrogance, anti-competitive bullying of other entities, price fixing, and customer abuse.
Meanwhile, under central bank and government control, our money has steadily become more complicated than it once was.
How do governments complicate money?
Western world administrations have been increasing the load that Pounds, Dollars and Euros have to bear, forcing them to carry onerous public burdens which are of no benefit to human beings who simply want to trade with each other.
Here are four heavy burdens that our currencies have steadily accrued. All are relatively new, having appeared in the last 100 years.
Burden number 1
Modern government operates a transparently simple policy when generating its own revenue. It looks for circumstances where the money we use changes hands, and it passes laws with onerous penalties which make one side of the transaction pay a tax, and the other side costlessly responsible for reporting and collecting it.
That's why your income tax is paid by you and collected by your employer, why your VAT is paid by you and collected by your merchant, your Insurance Premium tax is paid by you and collected by your insurance company, and your travel tax paid by you and collected by your airline/travel agent. There are many other examples.
After National Insurance, Income Tax, VAT, and other taxes specific to different products and services, the cost of money passing through private individuals' hands, as they earn it and spend it in one transaction cycle, is now frequently in excess of 60% of the underlying value of what they exchange.
Although taxes can fund valuable services there can be drawbacks to having tax at these levels. It suppresses trade and exchange in the many cases where the value added by specialisation is below the tax-rate. Sadly this generates a devastating effect on simpler jobs, because low value-added employment is charged tax (national insurance and income tax) on the gross cost of the labour rather than on the value added. This denies many people with less marketable skills the ability to find a way to contribute meaningfully to their society, by working. (If it sounds a bit radical that income tax and national insurance are bad taxes – because they tax revenue rather than value added – consider that ordinarily businesses only pay taxes on value added, e.g. profits. When it comes to revenue taxes businesses are treated much more sensibly than people.)
You must decide for yourself the level that free people, specialising and trading to their mutual benefit, should be taxed. But whatever your view it is without doubt the case that high tax costs in our transaction cycle makes it attractive to find other ways to pay. Of course the government cannot allow you to do that. Your freedom to find a less onerous scorekeeping system would harm its ability to take more than half the value of every trade you choose to make. So, in the way of so many monopolies, government uses its power to entrench our use of the currency whose transactions it benefits from. And having forced us to carry on using it, government imposes more burdens on the currency, making it steadily less fit for its real purpose.
Burden number 2
Over recent years government's main economic lever has been monetary policy, by which it seeks to direct the way our economies behave, primarily through the artificial manipulation of interest rates.
In the early 1900s the rate of interest was set by the marketplace. When there was a lot of money looking to be invested, interest rates would fall, and when there was too little they would rise. More recently – from around 1980 to 1990 – government was imposing startlingly high rates from the centre. In those days we used to accept these periods of artificially high rates, a policy graphically described as 'removing the punch bowl', which generally calmed things down if economies were threatening inflation.
From 2001 to 2020 we have only seen artificially low interest rates, which is the opposite of removing the punch bowl. Government is spiking the drink. Low rates keep governments popular when the economy would otherwise enter one of its natural slowdowns, and they make running a government on borrowed money much easier (which helps governments get re-elected). They also make businesses unnaturally profitable in the short term, which encourages them to expand and employ more people. And of course low interest rates also make asset prices rise.
Low interest rates usually encourage inflation, but for the last 30 years their tendency to do this has been nullified by efficiencies derived from the microchip. If that had been invented in the monetary environment of 1900 there would have been 30 years of three to four percent annual falling prices, as the productivity gains of this extraordinary technology worked through to a lower cost of living.
But in our era it allowed government to set an easy inflation target, of +2% instead of -4%, and set low interest rates while claiming it – rather than the microchip – was responsible for everlasting, low-inflation growth. Government has got us all properly hooked on the monetary cocaine of cheap debt, while accruing for itself most of the financial benefits of the information technology revolution.
Neverthless, thanks to the microchip, we have had relatively low inflation and low interest rates at the same time. It has felt good – for the unemployed, who get re-hired, for property-owners, whose houses go up in value, for businesspeople, who make bigger profits, and for politicians, who get re-elected. But as with most free lunches eventually there's a price to be paid – in this case by the future.
Artificial monetary stimulation of the economy cannot be brought to an easy end. Any mild economic downswing which seems to have been avoided in the short term is more than offset by the severity of a downswing which will later threaten. The alternative – and this is the path we have been on – is an irreversible slide in interest rates to zero, or less. (Negative interest rates are implemented by making depositors pay the central bank a mandatory custody fee, while at the same time not allowing the larger depositors at the central bank to print their balance off in banknotes, i.e. make a withdrawal which avoids the custody fee and keep their money in bales of cash at a professional vault.) That lets the world fill up with a toxic combination of very expensive assets and oversized, flabby businesses incapable of surviving in a properly tough environment.
For the generation that grows up while this is happening the world is unfair. Our cheap money bias has upset the relative value of labour – whose value has been suppressed by the same technology – while capital asset values have multiplied. It leaves the entrepreneurs of tomorrow without the savings to invest in their first business. They are trapped in low paying jobs in protected but stale companies whose resources are never released into the marketplace by competition, failure and liquidation. Creative destruction, and the progressive evolution it brings, slows to a crawl.
Meanwhile an older generation lives rather too comfortably renting out inflated value assets which the young cannot afford to buy.
Burden number 3
To fund its overspending government and the central bank conspire in the removal of the essential pillar of a sound monetary system: collateral.
In a world of private banks operating in a marketplace, debts are more than 100% supported by widely distributed collateral of marketable value; very typically mortgaged houses, factories and productive assets. Bad debts can then be honoured by occasional sales of that collateral in the market.
But we now have one extremely large debtor – government – which has overspent without providing any collateral. This overspend is the national debt.
Our national debt is £1.6 trillion. Having more than doubled in real terms within the last ten years its current size is an illustration of the problem with surrendering a monetary monopoly to people dependent on re-election! In Britain we have a £2.3 trillion stock of money (M2) and it is now only 30% supported by collateral. Thanks to the pressures of democratic government 70% of our money stock now has no collateral behind it. That's a situation which would have terrified our great-great grandfathers; they would have wasted no time in withdrawing their money from a system so lacking in collateral!
What our ancestors understood was that losses which eventually arise from under-collateralisation will not be apportioned evenly across creditors. Instead what will happen is that earlier withdrawers from the system will buy assets at prices which feel expensive at the time but which will later appear to be very cheap. Then, as progressively fewer takers of the increasingly 'fiat' money can be found, the laggards who still have a money balance because they have not 'unsuspended their opportunity to buy' will find they have to pay much more to get any seller to accept it. Those who choose to sit on their money balance for the long term will tend to see its value evaporate in a hyperinflation.
Hyperinflations are an ever-present threat to money systems, and are generally preceded by excessive public debt. Governments have a long history of removing the collateral support of money, by issuing themselves with ever greater quantities. This renders everyone else's money worthless through the resulting hyperinflation, which is essentially an abandonment of a monetary system by cautious creditors.
In the last 250 years hyperinflation has happened in almost every country in the world – in many of them several times – though exceptionally not yet in Britain.
Burden number 4
Since the introduction of the Anti-Money Laundering Act in 2004 government has put our monetary system at the heart of its law and order policy.
Previously, if we earned our money honestly, its history and the prior behaviour of the people we earned it from was not our responsibility.
But now, having introduced a wide range of new obligations for us to obey, governments have made all businesses responsible for detecting and reporting any potentially suspicious behaviour by their customers. Nowadays there are severe penalties for incorrectly assuming your customer's innocence, and doing something entirely normal – like transmitting money – in the service of a crook.
While, on the face of it, most of us our glad to see criminals' lives made more difficult, this extension of a judicial role to commerce forced businesses to act as jury and judge on their customers, without a trial, and with the assumption of guilt. Many thousands of innocents (for example, people with Arabic sounding names) are now routinely obstructed in their use of bank accounts by institutional prejudice triggered by a deeply illiberal law. Meanwhile the costs to business of the procedures of its new policing function have been extraordinarily high, and the benefits hardly detectable. After all, there are plenty of other scorekeeping systems for criminals to use.
Each of these heavy burdens is a consequence of there being a monetary monopoly enforced by government. They make our currencies inherently less fit for their basic scorekeeping purpose, and pave the way for a replacement. Bitcoin – for example – is the sort of monetary invention which follows from our regular currencies carrying all this government-inspired baggage.
How is money created?
However, the problem which Bitcoin does not and cannot address, and what assures its failure as a monetary medium, is that it can't vary its quantity to suit monetary supply and demand.
Real money is created and destroyed all the time, in the normal course of healthy business. We can easily see how this works with an illustration.
Suppose a builder agrees to build a garden shed for a wealthy magnate who has a magnificent and un-mortgaged house. The magnate tells his bank to pay the builder and the bank keeps the score by transferring some of the magnate's current credit to the builder.
But if the magnate started with a zero balance then, with the bank's help, the pair of them have just created money, because the builder now has brand-new, general purpose spending power where none previously existed, even if the magnate may now have an overdraft secured by a new collateral agreement on his house.
This was just people going about the business of free trade. The government didn't suddenly wave this money into creation, and nor did the central bank. It was a private arrangement between two customers and a bank. No-one needed permission.
The magnate's spending power has been created, indirectly, out of the marketable value bound up in his house, and the bank has acted as a responsible, enabling credit agent, without which a perfectly sensible shed building transaction couldn't happen. The bank lubricated healthy trade.
Before the transaction our magnate owned a house which nobody could force him to sell, because he owned it outright and had no debts. It was un-mortgaged, so it was an asset without a liability.
By signing something which permits the bank to grab his property and sell it if he fails to pay his debts, the magnate's house has become an asset with a liability – it is now collateral. In return he got the power to spend, i.e. newly created money. His bank created two scorecards in his name, one in credit – his current (checking) account, which allowed him to spend – and a loan account next to it, which will be in debit, with this debt being supported by the real marketplace value of his house.
In fact just as his shed building has here driven a creation of money (remember, it's only points on a score-card) our magnate's magnificent house has probably caused a destruction of money for many years, as the credits he accumulated through his business were used to pay down his original mortgage. When he'd finally paid it down his house had solidified his earned money into outright property. But getting there involved the elimination of a lot of money which he'd earned, as the credit he received for his work met the longstanding debt on his mortgage account, and they mutually annihilated.
Now, with the bank's help, the wealth tied up in an un-mortgaged house has been partially re-monetised to build that shed. Our magnate's property wealth has again become liquid, and spendable.
Doubtless in a short while the shed loan will be paid down, and the small amount of money created to get the job done will be eliminated again, as someone else's money passes through the magnate's hands and he uses it to redeem his shed loan and cancel his collateral agreement. Then once again he'll be the outright owner of his house; and now a shed too.
It's perfectly natural, and entirely healthy, for money to be created and destroyed all the time, in the normal course of business. Money is not strictly limited in supply like a commodity (or Bitcoin). It's like love, or trust. There can be as much of it as people want, or as little, depending on how much trust bankers place in the collateral value of their clients' private property, and also on how much the owners of that property choose to generate spending power from what they own. (Houses, gold bars, stocks and shares and shoes are all property, if they are owned outright. Not all of them are the sort of property which can easily be used to create money. That depends on whether they can easily be sold. Houses? Almost always. Gold bars? Yes – always. Shares? Probably, if they are publicly quoted. Shoes? Well, they have a value, but second hand shoes are not the best security for money creation! The 'property' we are interested in retains value and is marketable.)
In the end, how much money is created, or destroyed, reflects the prevailing wishes of many people freely choosing to hold their wealth in suspended, spendable form (i.e. money) or in property form. All of which means that in a moderately free economy the amount of money in existence can be left to regulate itself perfectly naturally. It sorts itself out such that supply, demand and price, even of money itself, can be left to the economic votes of millions of people pleasing themselves based on (i) the available supply of capital assets to act as collateral and (ii) how they choose to balance their outright property ownership and their monetary balance.
Unlike Bitcoin, this sort of money is created by natural demand, and derives its value – perfectly logically – from the real marketable value of capital assets. So, again unlike Bitcoin, it is well connected to real wealth.
- Bank capital is provided to the extent preferred by investors in banks, which will reflect how much demand there is for banking services and how much interest can be charged.
- Property is monetised – at banks – according to the extent wished for by its owners, and money is transferred between depositors' scorecards when they choose to spend.
- The banks underwrite this monetisation. They are motivated both to assist it, because it pays them interest, and to watch carefully over the value of their collateral security in order to guarantee the resulting credit with their cautiously extended shareholders' funds, which remain permanently at risk.
- Interest rates automatically find their own level through competition between banks, rising as there is too little spending power available to borrowers, and falling as there is too much. The supply of credit is guided by demand for it, and by the risks and rewards of granting it.
- The banks' stakeholders (both shareholders and depositors) keep an eye on the bank, and are motivated to do so, because the failure of their bank would cause both of them losses.
- Bank customers consume more, or less, as they wish, and deposit more, or less, as they wish.
- The occasional failure of a bank, with significant losses to owners, management, and even depositors, kills off reckless banks, and through these deaths, and the birth of new banks, banking as a whole evolves in the true sense of the word, like any natural population, towards configurations which survive and prosper.
A little over 100 years ago this is how it was. Private banks created money and the money they created was subject to natural economic controls. Meanwhile the role of government was largely limited to that important role of defining the unit of account (the currency unit) which ensured that all the various private organisations remained interoperable.
But those natural, self-regulating controls do not now operate. Instead government creates an amount of money which suits its electoral purpose, and it implements its policy through its direction of the central bank, while imposing increasingly illiberal and ineffective regulation to make up for the many weaknesses inherent in its approach.
Self-regulation does not mean 'unregulated'
Unfortunately one of the saddest changes in Britain over the last few decades has been escalating distrust of self-regulation and the liberty it reflects.
To someone who loves freedom "self-regulation" is stunningly elegant. It means that something works automatically through natural, regulating laws, and doesn't need a group of officials telling us all exactly what we should and shouldn't do.
A simple pendulum beating out time is self-regulating, and it is entirely natural. Ordinary physical forces apply to make it accelerate towards its point of equilibrium where, if left completely alone, it will eventually rest, until disturbed again.
The more remarkable thing, though, is that a big disturbance does not affect the period of a pendulum's oscillation. The natural physical forces of gravity and string tension have an increasing regulatory effect as it swings higher, making the pendulum's swing period unaffected by the length of the swing. Gravity, tension and angles neatly take care of everything, which, as ancient clockmakers discovered, makes a pendulum a natural timekeeper.
So when a clockmaker tries to capture the timekeeping quality of the pendulum the skill is to make as little impact as possible on natural pendulum behaviour, and to let nature take its course.
If our monetary system were allowed to swing under natural forces it too would certainly oscillate, much like a pendulum, through periods of expansion, when people want more spending money (and have the wealth to support it) and periods of contraction, when they harmlessly pay down debt and elect to hold their wealth in harder assets. This 'swinging' is what used to happen when our monetary market was left to regulate itself. The business cycle – which is what we called these oscillations – became quite widely derided, but it was this change of energy and direction which kept things dynamic – forever generating opportunity, not least for the young.
But our modern, regulated, monetary economy has been modified by government to work more like a central heating system than a pendulum.
A central heating system does not rely on natural forces, but on an engineering solution – a managed combination of thermostat and boiler. A preferred temperature is chosen away from the natural temperature of the room, and then energy is carefully organised to keep the temperature there. A central heating system is regulated by machinery, and ultimately people; not by nature.
A pendulum which has no energy input will always settle quietly at its equilibrium, and start seeking its equilibrium as soon as it's disturbed. But a central heating system will break when the thermostat fails, or when it runs out of fuel, or when it becomes too complicated and no-one can find the user manual. Then the temperature will collapse to a low point which no-one is used to.
This illustrates the important differences between a regulated and a self-regulating mechanism. In the whole history of the universe no pendulum has ever failed to seek its point of equilibrium. Through being elegantly simple it remains a 100% reliable equilibrium-seeker. But – again in the whole of history – not a single central heating system has ever been developed which can survive and continue to work for more than a few decades. Its mechanism demands sophistication, management and energy, which will each fail in time, with the result that thermostats, like all engineered solutions, are 100% unreliable over the long term.
Moreover when a thermostat fails there is a sharp shock to anything which depends on it.
Given these profoundly different performance characteristics there is a sound case for behaving like the skilful clockmaker and developing, where possible, systems which benefit from self-regulation under natural forces. They will last longer and require less management.
Now – of course – no pendulum ever heated a room, and many situations demand regulation. But good government in a free society is about detecting which do not, and having the strength to stand aside when they swing out of equilibrium, leaving people to be as free as possible to do as they will. In this way, in time, equilibrium will be regained, without all of us being strangled by regulation.
How successful we are at identifying and supporting self-regulation – where appropriate – is the real measure of how deeply rooted is our will to be free.
The slide to modern regulation
The denial of self-regulation for money, and assumption of control over our monetary system by government, is the true underlying cause of the relative impoverishment of the young in modern Britain.
Nowadays our banks are very far from being capitalist undertakings. They are substantially nationalised, and subordinated to the control that the central bank imposes on them. Their account opening, pricing, lending, capital, and risk policies are out of their own hands, and are dictated either by the central bank, or the regulator.
Yet most people think that free market systems, and the nominally private banks they are thought to contain, are to blame for the increasingly grotesque abuses in modern finance which make us all bristle with anger.
They have it entirely the wrong way round.
It is state intervention, manipulation, and regulation which has upturned the incentives of bankers, and made them what they now are. Under natural self-regulation all those repulsively greedy bankers at the worst of the banks would have lost their jobs as their banks failed. Costly failure would have evolved caution and discipline in the survivors. But, instead, the quick-profits culture was emboldened by repeated state rescue of the worst bankers who learned – very quickly – that they could keep the quick easy profits as bonuses, and that they would be baled out of the long term losses by the rest of us, as government took command.
Those of us born before 1970, and quite a few born after, know that economies run under the command of government, with a claimed mandate to protect us all, are a route to an unproductive, repressive hell. They produce societies like 1980's East Germany – where the economy was dire, liberty was non-existent, and people risked death trying to escape to the West.
Whether it was Honecker, Marx, Stalin, Brezhnev, Mao, Pol Pot, Jaruzelski, Ceausescu, Castro – or more recently, the Kims of North Korea, and Chavez of Venezuela – leaders of planned, command economies have generally presided over a worsening economic and civil nightmare.
Each of these men believed in the central and beguiling socialist idea that surely it must be the case that clever people (them) planning a detailed route to the future would achieve a better result than the apparently random fluctuations of the marketplace.
They were all of them wrong, not just in their intellectual denial of the elegance of economic evolution, and of the way it can naturally regulate itself, but also – which was worse – in the ugly totalitarianism they all imposed in attempting to make their creationist dreams a reality.
Their centrally planned solutions suppressed the collective will of millions of ordinary people who, left to themselves, would have participated automatically in a giant, continuous, economic election, where in the practical exercise of their economic freedom every cent they spent was a vote directing the economic world according to the wishes of the spender.
A free market is a magnificently efficient detector and tester of demand and innovation, and a disinterested executioner of obsolescence. People expend effort to sell into demand. Good new ideas gather revenue. Obsolete ones lose it. There is no more room for a grand, central design in economics than there is in biology, where (aside from a few cranks) absolutely everyone recognises that the system does not progress in a direction chosen by a creator.
On the contrary, a healthy market economy evolves in a way very similar to life itself, by the apparently wasteful generation of too many new ideas, by the expiry of those which are ill-adapted to their environment, and by the thriving of those which fit well into a niche. New businesses flow under the momentum of their own ambition and optimism into new opportunities, even if very many of them turn out not to be as promising as their innovators often hoped. Nevertheless, the ones which succeed more than make up for the many which fail.
By dismal contrast central planners are poorly placed to spot any seeds of innovation, and find themselves politically compromised and unwilling to shut anything down, long after it ceased to be useful enough to pay its own way. Central planning may have seemed like a good idea, but it leads to stagnation and misery. We know this is true because the second half of the 20th Century gave us ample hard evidence, and also because if we have even just a little understanding of the natural world we can tell the difference between evolution and creationism, even in economics.
So while those earnestly regulated, planned economies in the east groaned and sank through that grisly period of late 20th century economic history, the West's economies flourished and evolved, in the true sense of the word, by allowing themselves to be guided by natural market forces.
How we used to chuckle at the socialists and communists, who always thought that the only things they were missing were a few more government officers telling people what they should and shouldn't produce, consume, do, and – eventually – think.
Yet so far as our monetary system is concerned we in the West are now thoroughly East German in our approach. We have abandoned the self-regulation of the market and copied the top-down rulemaking of the central planner.
Since 1988 our monetary system has been rebuilt as a mass of regulations, none of which existed in the period when we were so convincingly outperforming the East. Enforcing the rules – for reasons they don't understand or question – we have completely new armies of 'compliance officers' made peculiarly unpleasant by their jobs. They have increasing powers of inspection, authorisation and arbitrary punishment. We've created a financial secret police not so different from East Germany's feared Stasi, forcing potentially productive people to keep their heads down, achieving nothing. In a modern bank, nothing can exist outside the ghastly grasp of "compliance".
If you ask a modern compliance officer what the purpose of it all is they will (mostly) tell you that it's 'to defend the integrity of the financial system'. Substitute "state" for "financial system" and it's a line perfectly echoing the feared East German Stasi. It's impossible for them to recognise their own malignancy, and their effect on what they believe they're defending. Their quietly destructive influence progresses like a tumour, destroying ever more parts of the market system every year with unnecessary extensions of their powers, as they write yet another chapter of rules, and put another segment of our financial system into over-regulated lockdown.
One illustration of the aggressive and malignant culture of 'compliance' is how it has overturned one of the greatest achievements of 800 years of British history. Since the signing of Magna Carta in 1215 the British appreciation of freedom gradually separated all the important powers of our justice system in order to provide appropriate checks and balances. Parliament set down laws. The police investigated possible transgressions. The Crown Prosecution Service decided whether or not to prosecute. Fair trials were witnessed in public courts. Ordinary people sat on juries to decide on guilt or innocence. The judge declared the punishment.
It is hard to believe that in the course of just 30 years we have so completely changed direction, creating a system where all of those powers – in so far as they concern our money – have been consolidated under a single, immensely powerful, financial regulator. It now makes the rules, controls the investigators, prosecutes who it likes, has dispensed with the jury, and pays the salaries of its own judges. Worse, it is allowed to keep part of the fines it imposes to recover its costs of enforcement – money it will not receive on an acquittal. Still worse again, you are not at liberty to start a business independently of it, because it has been granted a monopoly right to sell you an expensive operating licence before you start. The law now declares you a criminal for operating without the licence. The regulator prosecutes you for not paying it a fee. It's a modus operandi very much closer to the Kray twins – boxing thugs who ran protection rackets in London's East End during the 1960s – than it is to a traditional bank operating in a free market.
We survived remarkably well before all this came into existence in 1988. So why does this illiberal, overbearing regulator exist at all? Only because it had to be created to try (unsuccessfully) to correct the mushrooming unintended consequences of thoroughly bad policy, all arising because government broke the marketplace when it stopped self-regulation from working with money.
The effects of protecting banks
The game of cricket (or baseball, if you prefer) works because the fielding team are motivated to bowl hard, and catch well, to remove the opposition's batsmen. Imagine a new version where, out of a desire to let a larger number of less-capable batsmen enjoy a safe innings, the cricket authorities declared that no-one would ever get out.
Unfortunately the efforts of the fielding team would instantly become irrelevant. The batsmen would take ever sillier risks, the fielders would start dropping catches, the bowlers would put on weight, and so on. Eventually those same cricket authorities, frustrated by widespread degeneration, would start making rules about what constituted appropriate effort. They'd regulate the batsmen's permitted techniques, the bowlers' diets, the fielders' catching practice hours, and their evening drinking habits. Enforcement would be the responsibility of a new set of cricket compliance officers, paid for by a levy on all the players. They'd describe themselves self-importantly as 'defenders of the integrity of cricket' and sit in car parks watching pub doors, all in a forlorn attempt to re-create through a long list of illiberal regulations the game that used to work so well with a single harsh reality that every cricketer used to accept: batsmen get out.
In much the same way, to get the benefits of its self-regulation to work, the marketplace demands a price. Like batsmen getting out it insists upon a cost of failure, which in business means loss, and yes, sometimes bankruptcy. This threat produces the single force necessary to make the market work, because it engages the minds of everyone who has a stake.
With that engagement most businesses have no requirement for regulatory micromanagement from outside. The commercial directions which organisations take, and the money they make or lose, become a private matter of free people making their choices and gaining their rewards, or paying the price for failure. Liberty and innovation prevail because government is not involved.
For our money to work as it should, guiding people into wise courses of action, and weeding out the errors which result in failure, we have to avoid making banks a special case. Businesses will always fail, and with its natural, unconscious ambivalence, what was so aptly called 'the invisible hand of the market' simply shrugs at their loss and silently suggests to the next banking entrepreneurs, and to their depositors, that they look out carefully for the poor decisions and behaviours which did for the previous banking casualty. Every failure tunes the senses, and educates everyone.
The failure of a bank is no more than a normal business failure. Its creditors will lose some (occasionally all) of their money. But so what? If there is a risk of loss when customers make deposits they will make them more carefully. They might even take out their own deposit protection insurance – privately. Either way, it should never be for everyone else to compensate the wealthy for their lost bank deposits. That's like requiring patient bus passengers to pay compensation to the owner of an Aston Martin, who lent it to a well-known drunk, who then drove it straight through their bus queue!
The free market is the ally of the young. They should be demanding that banks are allowed to fail under its rules, and they should insist on rich depositors paying for their own risks. There is currently up to £85,000 of free, state compensation payable to depositors in failed banks. Its current rules defend the deposit, not the depositor, which means that a very wealthy person who has made five failed but carefully sized deposits in the five highest interest paying (and riskiest) banks, and sees them all fail, will be rewarded with compensation five times – worth £425,000 – paid for by the people who weren't taking any of those risks in the first place!
The existence of this state mandated deposit protection is the key driver for all that dreadful and ineffective regulation. The flawed thinking goes that if government is the guarantor of the errors of the banks then it should be able to control the risks they take – through regulation. But as bankers have shown us so clearly, external regulation simply cannot keep up. Bankers who are protected from long term losses can always find a trick which generates an easy – if risky – short term profit. It'll pay the bonus this year, and the rest of us will eventually end up footing the bill.
The first step of the solution is stunningly simple. Deposit guarantee compensation should be scaled back, gradually perhaps, over a few years – from £85,000 to well under £10,000; no more than is enough to protect people of modest means for a few weeks. Individual savers should be entitled no more than once every 10 years. Let banks fail – whatever their size. Then liberate the banks from their central bank straight jacket, and reform the Financial Conduct Authority allowing it to concentrate on more important things than whether or not wealthy shareholders and depositors in banks lose their money.
Letting banks and deposits die from time to time is an essential part of the process of 'creative destruction' through which economics so closely mimics biology. 30 years ago we made a terrible, East German mistake, by employing an army of Stasi style regulators to impose a command structure on our financial system. The results are (i) a powerful government bias in favour of cheap money, (ii) high asset prices, (iii) too many stale companies on long term life-support, (iv) dangerous (but personally rewarding) risk-taking by bankers, and (v) lazy, and non-productive deployment of wealth, for rent, by the rich.
All of these negative effects oppress the young.
In time – quite possibly after a dose of hyper-inflation – our brightest young minds will certainly understand all this very clearly, and their energy will haul us back to the liberties, the opportunities, and the risks, of free markets. The question is, will frustrations with an unjust financial system open the door to the phantom attractions of Marxism and an ever more state-directed economy. It would drag them, and their children, through 60 unnecessary years of failed experiments with command economy socialism and its enforcers. As two generations of Eastern European and Chinese citizens found out for themselves in the 20th century, that is Friedrich Von Hayek's "road to serfdom".
Footnote:
Although the EU did not invent Deposit Protection, it enshrined it. EU Directive 2014/49/EU mandated the implementation of €100,000 [£85,000] Deposit Guarantee Schemes in EU member states. From January 31st 2020 it need no longer apply in Britain.
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