Thursday, March 12, 2009

Inflation as Loss Function

Banks create money and then lend it to borrowers. The quality of projects that banks select will cause inflation, stable prices or deflation. The best quality projects would cause productivity to exceed the amount of money created, and so monetary expansion to be deflationary. If projects that banks select just equal the average quality of economic productivity then there will be neither deflation nor inflation. If banks consistently choose projects that are inferior to the average project with respect to productivity then there will be inflation.

This suggests that inflation can be viewed as a quality loss function (see discussion in Taguchi). The target loss should be negative. Economically, diminishing marginal productivity suggests that as more money is created losses will be greater. However, if banks are competently run and have adequate quality processes with respect to project selection, they can offer loans to projects and sustain zero inflation.

The management of banks becomes a critical problem to economic welfare if the banks themselves lack quality management capacity to select loans. This has been the case. It is impossible for outsiders to design quality processes that will improve loan selection because this depends on identification of borrower and project characteristics that are only known to lenders.

There is no literature on selection of entrepreneurial risk by lenders. This is not a topic that academics have treated and it is not a topic that bankers have carefully considered.

As a result of the absence of quality processes in making loans, the financial system has failed to make loans effectively. The current financial process results from quality losses, i.e., the Taguchi loss function among banks is large and so results in bad loans. Consistent inflation since the establishment of the Fed suggests that banks have failed to develop competent quality processes in lending.

Anecdotal evidence suggests that banks have consistently made loans based on incompetent criteria: to large institutions who cannot make good use of the funds; to firms with close connections to the banks and to firms engage in activities that loans other banks are making. This mimetic pattern suggests a financial system that is, in Deming's terms, "out of control". A competently run banking system would permit economic expansion coupled with stable prices.

The banking system requires restructuring to facilitate adoption of competent, quality driven practices with respect to lending. Banks must become competitive. Banks which fail to produce loans that generate net gains to society (i.e., deflationary loans) should be refused access to Federal Reserve bank credit.

Tuesday, March 10, 2009

AFAQ--Uninformed Anarchist

On a blog called Anarchist Writers someone, apparently an anarchist writer, with the pseudonym "afaq" (which seems to stand for "anarchist frequently asked questions"--I guess anarchist writers lack the guts to use their own names) displays some anarchistic ignorance. Afaq, an anarchist* who believes that state violence should suppress private economic activity, writes:

"A 100% reserve system is not a reformed or true banking system. It is the abolition of the banking system. Without fractional reserves, banks cannot make any loans of any kind as they would not be in a position to give their clients their savings if they have made loans. Only someone completely ignorant of a real capitalist economy could make such a suggestion and, unsurprisingly, this position is held by members of the "Austrian" school (particularly its minimum state wing)."

Despite afaq's crude name calling, afaq appears not to have heard of savings banks. Perhaps a reading of Murray Rothbard's Mystery of Banking would inform this confused soul of the difference between full and fractional reserve banking, and of the evolution of fractional reserve banking after the beginnings of capitalism through goldsmiths' fraudulent issuance of notes on non-existent gold. Moreover, several states illegalized fractional reserve banking in the nineteenth century, and capitalism did not suffer.

Only someone ignorant of how banking works and of economic history would be unaware that fractional reserve banking is not full reserve banking. Fractional reserve banking exists where loans are made without reserves, as is done by the US banking system, where loans are 2 to 10 or more times greater than the monetary base or reserves. Eliminating fractional reserve banking means requiring banks to have reserves in order to lend them, not preventing them from lending reserves. Any student of elementary economics learns this, but it is clearly beyond afaq's knowledge, which does not prevent afaq from expounding pointlessly and confusedly on numerous topics about which afaq is ignorant.

It is characteristic of the left to call others ignorant when they themselves lack the most elementary familiarity with a subject.

*Characteristically, the left adopts nomenclature that is opposite to its meaning. "Progressives" advocate ideas that are four centuries old and were characteristic of mercantilists. Their ideas are guaranteed to stop progress. "Radicals" advocate communist ideas that are appropriate to feudalism, were well known two thousand years ago, and whose adoption would but re-enforce the root of current big government corruption. "Liberals" advocate anti-liberalism and statism. And of course, "anarchists" like afaq advocate governmental suppression of freedom.

Sunday, March 8, 2009

James Dale Davidson's "The Plague of the Black Debt"

I am cleaning out my New York City apartment in anticipation of a final move to West Shokan, NY. The biggest problem is all my books. I had to discard a number of old books, including many of no-longer-used labor relations books from my doctoral program. I came across a tiny soft cover volume published in 1993 by James Dale Davison, founder of the National Taxpayers' Union. I don't remember where I got it. Here are some excerpts:

"The Fed has been pursuing a loose money policy for three years, and the money supply is still falling like a rock. The Fed has moved heaven and earth to get the money supply up, and it's not working...the markets are confused because interest rates are going down, and that is always good for the stock market. At least that's what people think."

Davidson points out that monetary expansion does not work if banks are failing or contracting. He notes that in the Great Depression the Fed reduced interest rates but the money supply still contracted because of bank failures. The process did not occur in the early '90s as Davidson feared, but is what many fear is happening now.

Here are some of Davidson's predictions from 1993:

>I see Social Security benefits being cut to the bone. They'll probably only go to the most needy.

>I see at least 40 million unemployed to make-work public assistance jobs

>Sick elderly will be cared for at home. Almost no one will be able to afford nursing home care.

>I see millions of homeowners upside down--with the mortgage bigger than the market value of the home. A lot of them will hand the key to the lender and walk away. There will be a lot of empty houses with "For Sale" signs.

>Banking industry problems will return, much worse than anything we've seen. And much too big next time for the government to bail out. Either your savings will be wiped out or you'll be paid in worthless paper dollars.

>I expect to see 'extended families of 10 to 15 crammed into three-bedroom houses. Millions of retired folks will be forced to live with their children. Young people in their twenties and thirties--including young marrieds with their children--will move in with their parents. In many cases, not a person in the house will have a full time job.

>The suburbs will become slums

Davison argues that knowledge workers will become affluent.

>Small communities two hours away from major cities are the fastest-appreciating real estate in the country. These communities are already benefiting from the "Fifth Migration" in American history. The Third Migration was from the farms fo the cities, and the fourth (1950-70) was from the cities to suburbs. Now, people like us are bailing out and moving to small, clean, safe towns. Technology makes it possible for us to work anywhere...Even if you're not ready to move yet, a rental property in these areas is the best investment in the United States."

Quite a coincidence. Hello West Shokan.