Financial Cryptography

Why Central Banking will fail in the next N years -- and how Central Bankers might prepare us for it.

I think I have already predicted the apogee of Central Banking in claiming that the 20th century was theirs. It is not entirely clear what happens next; we won't know that until we (or they) build that future, and CBs themselves lose all their power such that they step aside and allow banks to fail.

That said, it is a rather dramatic prediction. So it behoves to review it from time to time. And to seek other opinion! With that in mind, I present a long essay from BullionVault's Paul Tustain, who starts out by saying:

I'VE ALWAYS been fairly sure you can't print money and get away with it indefinitely. But I couldn't well answer the question "Why not?"

It turns out the recent head of the British financial services regulator is similarly uncertain. He recently suggested the Bank of England write off half of the government's debt, which comes to exactly the same thing as printing money. How wonderfully simple. Of course it must be wrong, but why?

You can read the whole thing for the fuller answer. I'm just going to cherry pick. Firstly, show that a reminder that we need money:

CHIMPANZEES don't barter, but they trade a variety of delayed favours we won't go into here. South American vampire bats are more sophisticated, and run a small credit economy. The little darlings have such a need for blood that they lend, borrow and pay back amongst themselves rather than let a relative go bloodless for a whole night. They somehow manage to do the whole thing without plastic cards. A credit card – of course – is a device which creates both credit and debt, and you can spend the credit bit, which unfortunately leaves the debt bit overhanging, though oddly absent from the device's name.

Pure, distilled credit usually arises from us doing some work (labour), or transferring our property to someone else (selling goods). Either way, we generate an unreturned favour. So I'm going to call a unit of credit an 'Uf', and wherever possible I'll use the word 'Uf' instead of credit. Somehow it makes it much easier to understand what the hell is going on.

Chimps and vampires show that credit occurs naturally, just as it would have for the earliest humans. Beyond the smallest number of transactions it would have quickly become hard to agree who owed unreturned favours (Ufs) and to whom. Then somebody had the smart idea of using tokens to represent Ufs.

It is quite an important observation that money is simply an accounting system for favour returns. If we were to formalise this notion, money would be an accounting system that works in a world of many parties, where each are individual actors. (Some would say byzantine actors, others would say crooks.) In contrast, the accounting systems we actually call accounting systems, the ones we normally have occasion to use, are more simply which work well with only one party, self or or our employer, and there is a reasonable expectation that self does not steal from self.

The point here is that when we create money we are building an accounting system. And we might have different ways of doing that... Indeed we might set up an accounting system where someone stands in the center and lets users pay each other:

Vampires bats can't do what we can which is to formalise our simple transaction onto an account by booking two payments through the bank. If your friend were to pay you through the bank for the original favour you did then you could spend your Uf anywhere. Banking is useful, like Uf tokens are, because an Uf you earn from your friend, then record at your bank, becomes available for you to pay anyone who's got a bank account.

And now I'd like to step in and reveal a crucial distinction. Where Paul has started talking about banks, he has now drifted to payment systems. Pin this point on your wall above your monitor or laptop - there are banks and there are payment systems.

Banks happen to have payment systems, but banks also have credit. Why and how does credit exist? He explains it in some detail, but here's a succinct para:

It is pure nonsense to say that a gold standard means all money should be backed by vaulted gold. Suppose it was. It would prevent a man with a paid up £100 million property portfolio from borrowing £10,000 from his bank to pay someone £10,000 to build a garden shed. A monetary obstruction to this deal just isn't going to be tolerated, and it's a stupid idea to suggest the deal should be blocked simply because the consumer (rich property owner) or his bank currently has no gold at hand. It was precisely this sort of economic blockage that caused people to create money in the first place, and if you try to stop willing and credible exchangers from using one type of money they'll simply abandon your money, and either use someone else's or create their own.

Which is to say - people with wealth will work with credit, and credit will arise naturally to assist those people, in exactly the same way that money itself arose (which is nothing more than a credit system for favours done in the past).

Credit is natural. Now the question turns to how we deal with the industrialisation of credit in a banking system, and the more particular point of what happens when a bank over-extends. In a stable banking system, other banks knock on the door and get their agreed collateral back. In a Central Banking system, the banks pass their combined position to the CB who nets it. Paul introduces Brad's bank, one that acts badly, and is enouraged to act more badly:

....When his bank deposits its balance at Brad's bank to Central, then it clears away its risk of Brad's bank's failure. It is Central which will now be exposed to the failure of Brad's bank.

The role of Central Banking is (or has become) to take on the risk of any bank failng.

....It also explains that the last bank in the chain is accepting the risk that Brad's bank can't return the Ufs, and because banks can get off that risk by drawing a cheque on Brad's bank and depositing it into Central, the Ufs created by Brad's bank usually end up owed by Brad's bank directly to the Central Bank.

And banks take on that role with relish.

These days Central is feeble, and frightened of the political consequences of any bank failure, so it lets Brad's bank run up an ever growing balance on ever weaker collateral. Other banks can deposit any of Brad's bank's junk at Central. Central's bluff (that it might close down a dodgy bank like Brad's) has been well and truly called. If you are a sound bank you can now do stupid business with a bad bank which you know can never pay you properly, and it won't hurt you.

Because Central's Governor has made it known he won't let banks fail, he has set himself up as the patsy.

To ground this story, Paul puts it in today's financial speak:

The resulting huge Uf balances at Central can be made grand and confusing by saying "The Bank of England's Balance Sheet is expanding" which I'm sure makes everyone think it's doing a remarkably important job. What it really means is that the Governor won't demand that a busted bank pays up or shuts down, so Central just runs up an ever bigger deposit balance at an ever weaker bank. While Central permits this Brad's bank really is being allowed to 'create money out of thin air'.

In short: Banks ran ever bigger loan exposures, because they had to compete on dividends. They cleared them through the Central Banks, which declined to shut any down. Therefore the Central Banks expanded their balance sheets to hold the risk, thus further encouraging the banks to do more and more.

Indeed the current set up – where banks are not allowed to fail – turns out to be even worse than I previously thought. It does much more than offer succour to the odd unfortunate bank which steps over the limit of safety. It actually forces banks to be dumb. They have no choice but to approach the safety limit until they are bound to step over it. Any bank which does not step up to the plate will underperform all the others, and be subsumed by a more aggressive competitor. It's how evolution works; the survival of the fittest, where fitness means adapted to the prevailing environment. If you do not compete in the skewed environment where the Central Bank is a wimp you will expire because of it.

That's why banks are forced to make rosy judgments on the value of collateral.

Precisely. The regulatory environment *requires* banks to compete in badness. They cannot innovate (take on risk not understood by the CB), and they cannot seek to avoid being commoditised. Thus the only thing they can do is compete on dividends to their shareholders, who are guaranteed by the CB patsy.

If all of them act like this, they must all overstep the bounds, and the system must fail.

Central Banking is thus the problem NOT the solution. And therefore has grave difficulty in being any part of the solution, even if all the actors in the Central Banking world are honest, hard-working and try their darndest to avoid the inevitable.

Once we understand the theory of why Central Banking must fail, in the end, we all naturally reach for predictions and solutions. That's tough. Nobody who is in control has an interest in stopping the rot, all of us outside have no power. So the result will be unpredictable.

But maybe some good things can be snuck through to prepare for the inevitable.

Let's now return to the events of 2007-2008 because it brings forth a singular lesson. When the crisis of Lehman Brothers hit Britain, panic spread through the banks, and in a knee-jerk reaction to protect themselves, they refused to deal with each other.

Bad idea. In an effort to keep the banks working, some banks turned to new teams. E.g., sack the executives. But, as the story is widely told in private banking circles, one man held a gun to the banks' collective head and refused to go.

So long did he hold that gun that it was estimated that his bank was 2 hours from shutting down their ATM network. And if that bank's ATM network was shut down, all the others follow suit.

The entire British payments systems were 2 hours from freezing solid.

People in power in London well know what the people outside London, outside of power, are capable of doing - recall the Poll Tax riots? Or more recently?

So we now see the real fear behind the deadly embrace that Paul outlined: Central Banking will fail and take the banks with them, the banks operate the payment systems and the failure of them will cause society to screech to a halt.

The silver lining that can be brought out of this is that payment systems, and indeed other innovations, can be allowed to emerge out of society. Payment systems can be divorced from banks, and to a large extent this direction can be see in the European monetary regulations of the last decade (PSD and eMoney directive).

Central Banks cannot get off their rollercoaster ride to credit-fueled doom, but they can ensure that newer innovations are not coupled to their journey to destruction.

Consider Kenya and Tanzania, countries that now have THREE mostly independent payment systems: cash, banks and mPesa. If all banks were to fail, shut the doors and the ATMs were to go broke, then the people can turn to the other two. Cash transactions will suddenly be king. And as long as the mPesa system is able to operate divorced from the banks, it will become queen.

mPesa already handles something like 20-30% of the GDP of Kenya, and something similar in Tanzania; if it can pick up more load, then this society might survive. As long as cash and electronic can still circulate, people can eat. Credit will be frozen, the middle classes will be screwed, but as long as people can eat, the bloodshed will be less pronounced.

A country like Britain which has long handed the monopoly of payments to the banks will not have this option, and remains in its deadly banking embrace. Hence, their better bet would be nurture and encourage the innovations: BullionVault and their close cousin GoldMoney. Zopa. Alternative payments systems under the eMoney directive, and independent systems under PSD. They should pray for an mPesa.

The question then to the Bank of England is not how much governance they wish to load onto these innovations, but rather do you dare run the risk without them?

Posted by iang at December 23, 2012 01:59 PM | TrackBack