The Horrible Slide

"On a long enough time line, everywhere is Greece."

- Detlev Schlichter.

One of the key functions of a modern bank (i.e. one which acts as more than a mere safe deposit box) is to coordinate time preferences for savings and investment. Some people prefer to save money, whilst others decide to borrow; a bank coordinates this transfer of money from savers to borrowers and back again via interest rates. When enough people prefer to save for the long-term, interest rates tend to be set low. Conversely, when enough people need to focus on short term necessity, interest rates tend to be set higher. This core function of coordinating the savings of some people with the borrowing of others is distorted beyond all recognition by two things: one is the fractional reserve system and the other is the fiat nature of modern currencies issued by central banks.

The fractional reserve system refers to a set of banks operating on an interesting principle: of the total value of savings and demand deposits received, only a small fraction (in Taiwan this is 8%) need be kept in reserve to cover withdrawal demands. All of the remainder can be loaned out by the bank to generate income from the interest rate. Under a fractional reserve system, bank deposits can thus be in two places at once: in theory, they are still available on demand at the bank yet at the same time they have already been put to work as loans. This arrangement works fine so long as a critically large number of depositors do not attempt to withdraw all their deposits at the same time - an event which is unlikely except in the case of a collapse of customer confidence during a bank run.

The fiat nature of modern currencies (such as the NT$) consists in the fact that their notes are redeemable for ... nothing. As such, the money supply under a fiat currency system is elastic, with the central banks regulating this supply largely by the adjustment of interest rates. However, their regulatory tendency is to keep interest rates low and therefore keep the supply of money set in an expansionary trajectory (for example, the narrow monetary base of the NT$ has continuously expanded over the last six years from NT$1.7 trillion [US$58 billion] in May 2006 to NT$2.6 trillion [US$89 billion] in May 2011). It is partly because interest rates are kept low by an expanding supply of cheap credit issued by the central bank, that these interest rates cannot accurately reflect the actual time preferences of savers. Thus we see the interest rates that banks offer savers are typically less than the rate of inflation, at perhaps 2% or 3% per annum at most. Would-be savers in need of higher returns on their capital instead shuffle off to try their luck on the stock-market or with the mutuals. If it were otherwise, that is, if interest rates were not artificially depressed by the monetary policy of the central bank, then one consequence would be that banks would probably offer fewer loans at higher rates of interest, thus creating better security for savers who would no longer need to risk their savings on the stock market for a decent return. A far more important consequence however, would be that fewer loans at higher rates of interest would significantly alter the structure of capital investment throughout the economy. In Taiwan, it may be that far less money would go into the construction business for example, and far more into new environmental technologies (e.g. water recycling systems). This is a subtle point, but of immeasurable consequence.

The cheap loans made available to the commercial banks from the central bank also allow for the multiplication of the amount of money in the economy - the monetary base - by issuing more in both business and consumer loans than they have received in savings deposits anyway (this multiplier effect is aided by their issuance of things like checking deposits and money substitutes such as credit cards). So whereas Taiwan's narrow monetary base (M0) for May 2011 is NT$2.6 trillion, the monetary aggregate (M2) is actually more than twelve times that at NT$31.6 trillion (US$1.09 trillion - hit the CBCrm "more information" link for an excel download - the same table is available as a word download elsewhere on the site). That is why Taiwan's banks were able to issue a total of NT$19.6 trillion (US$677 billion) in loans last year (as of May this year, that figure is now NT$23.5 trillion [US$811 billion]), whilst actual savings deposits accumulated over time amounted to no more than NT$13.6 trillion (US$469 billion)*.

What this means is that the economy is substantially inflated and distorted beyond what would be its true size, and crucially its true shape, under conditions in which interest rates reflected the time preferences of savers more accurately. Some areas of economic activity may be little more than bubbles inflated by cheap bank loans (part of that NT$19.6 trillion of last year); when enough such areas of sufficient size do eventually pop, then the banks will be left with a lot of "distressed assets" on their hands, i.e. the quantity of their non-performing loans will expand rather suddenly. Depending on how large a proportion of the total aggregate of bank loans these NPLs make up, the central bank may decide to purchase them by substantially increasing the monetary base. This is what is known as "quantitative easing" (or in Austrian circles, "debt monetization"). It is essentially a policy of printing money, one which debases the value of the currency (bad for savers everywhere, whether in the banks or in the stock market) and thus begins to slowly open the door that much further to everyone's nightmare monster: runaway price inflation.

The distortion of the capital structure is not exclusively achieved by the lending policies of the banks however. Very large quantities of money are wasted spent in what demands to be known in accord with conventional politeness as "the public sector" (but which really ought to be referred to as "the parasitical sector" or "the socialist sector" in order to bring to clarity the principles through which it draws breath). Consider: Taiwan's government debt is currently over NT$21 trillion (U.S.$727 billion) whilst Taiwan's nominal GDP for 2010 was estimated to be somewhere slightly north of NT$12 trillion (U.S.$420 billion). The government's debt is therefore approaching twice the annual size of the economy. Meanwhile, the profligacy of government spending continues despite these monstrous numbers: revenue for this year is approximately NT$1.6 trillion (U.S.$55 billion), with most of that money spent on (mal)education, healthcare, other forms of social welfare - and also defense. That expenditure will amount to NT$1.79 trillion (US$61 billion) - resulting in a NT$159 billion (US$5.5 billion) deficit. In order to pay down its debt from realistic surpluses (let's say NT$159 billion per year), and not counting changes in the value of the NT$ over time, the government would need 132 years to pay off the national debt!

Should this level of government spending continue, the danger to the people of Taiwan is that a future economic bust (perhaps the next one?) will sufficiently impact against both savers and businesses so as to substantially reduce government revenue. If and when that happens, the government may either seek to borrow funds from the PRC** or it may impel the central bank to embark on a policy of "quantitative easing" not only to buy up "distressed assets" from the balance sheets of the commercial banks, but also to purchase parts of the government's own debt, which, as we saw above, is almost twice the annual size of the economy. Either of these two policies might well be sufficient to precipitate either political annexation or runaway hyperinflation and eventual currency collapse: I very much doubt that the monetary base can be expanded from NT$2.7 trillion to absorb even one 10th of the government's debt without causing significant inflationary pressures. In order to stave-off having to take either of these two options therefore, it is imperative that the central bank of Taiwan pursue a more cautious interest rate policy (and, given recent rate hikes, they seem to be leaning in that direction) but, more importantly, that government spending across its' four largest items - education, healthcare, defense and other forms of social welfare - begins to be seriously cut.

Now I am not arguing anything as absurd as that such things as education and healthcare should not exist or that they should exist only as privileges for a well-off middle class - contrary to the mad, tropical delusions of the diseased wing of the Left. No. The first aspect of what I am saying is that putting capital to use on principles unresponsive to market conditions is inherently wasteful; the second aspect is that it is worse than that: the principles to which government "investment" in maleducation, healthdare, social hellfare and so on are responsive are those on which the acquisition of political power is most effective. I would think it a likely conjecture that the growth of government spending on such services is proportional to the increase in the production of professional politicists***, which occurs primarily in and through the universities and other educational institutions whilst stewed in a broth of pop-culture.

What are the possible solutions? Well there are two proximate problems; one is fiscal and the other is monetary, although both derive from the presumptions of monopolized political power. On the fiscal aspect: either a proactive program of boldly reducing government spending is taken up or the government begins to default on its debts (or perhaps both, though I think certain consideration ought to be given to the question of defense****). On the monetary aspect, either the central bank attempts to pull off a 100% reserve reform of the banking system to be followed by a return to a commodity based currency (though I have both ethical objections to, and practical doubts about this), or the government abolishes legal tender laws (which would allow the possibility of competition in currency). Neither of these possibilities has any remote chance of happening - at least until it becomes too late. So what to do in the meantime?

Keep an eye out for events in respect of independent, digitally distributed electronic currencies such as Bitcoin. If it really begins to take off (how to measure this - a 100,000 users?) and government attempts to hamper (or sabotage) it in the meantime fail, then it could potentially be a real game-changer in ways we can only begin to imagine and that would absolutely dwarf the impact of something like Wikileaks.


*Some more detail for balance: the total number of deposits was NT$25.8 trillion (of which demand deposits were NT$2.7 trillion), contributing to a liability total (including equities) of NT$30.4 trillion. Against that, the NT$19.6 trillion worth of loans made up 60% of the banking sector's combined asset total of NT$32.5 trillion. Of those loans, there was NT$8.5 trillion worth of long term loans as against NT$6.2 trillion medium and only NT$4.5 trillion short term (I don't have any data on loan maturity matching policies). The two largest State-owned banks, Bank of Taiwan and Land Bank of Taiwan, loaned out just over NT$2 trillion and NT$1.6 trillion respectively (if that seems small, bear in mind that Taiwan has, I think, something like fifty domestic banks [although some of the smaller ones have been bought by the larger ones] along with twenty eight foreign banks and numerous other credit issuing organizations). The number of banks in Taiwan is ridiculous.

**Borrowing from the PRC is... seriously undesirable.

***Note: not mere politicians.

****Though that doesn't mean I think everyone should be forced to pay for it.