FDIC insurance is the only thing giving the CD investor that certainty. Anything above $100K is lost if the bank goes under. Without FDIC nothing is insured at all and his only guarantee is backed by the credit of the bank. But this is still not the whole point. Opportunity cost doesn't disappear because you choose to ignore it. Nor can the risk to any CD above $100K.

The Fed effectively regulates this rate through open market operations, so the rate rises at the Fed's command. It's true that you don't now what the Fed will do, but your uncertainty doesn't imply a free market. No one knew what Mussolini or Stalin would do either.

I think you give too much credit to the Fed to be able to effect rates. Like OPEC, it's pretty successful in regulating short term rates in a small range. But if market opinion varies significantly, the Fed loses that control quickly. Ultimately, the market dictates rates at the short end of the curve. The Fed has long ago admitted defeat at the long end.

Real assets can appreciate, but money is an accounting device rather than a real asset. It accounts for the holder's entitlement to consume. When you hold money, you're playing an entitlement game with monetary authorities, and this game is like the market only insofar as monetary authorities construct the game this way.

I don't disagree with you. Here, I think we have a jargon issue that I think we should clear up. "Real assets" are physical assets like land, houses, gold, oil. But the term "asset" can be applied to shares in a company, which are a claim on the company's residual income as well as credit extended to companies in the form of bonds. When I say "assets may rise or fall in value", I include all types of assets. Real assets are expected to rise with inflation, but bonds will fall in value and stocks may rise or fall depending on many variables as inflation increases. This is why savers, who are often invested in stocks and bonds, lose when inflation rises.

It's a real loss of entitlement to consume, compared with the entitlement that might be earned otherwise.

No. when opportunity cost rises, there is a real loss of value. I think you're going off on a tangent. It may be a worthy tangent, but it's not relevant to this subject.

In principle, individual banks could do the same without a central bank. The central bank is only a regulatory authority presumably preventing individual banks from creating money excessively by setting reserve requirements among other things.

I'm with you through that whole section from which I excerpted the above bit. Maybe we're talking past each other, but whether the bank lends 2 dollars for every 1 dollar in reserves or 100 dollars for every dollar in reserve, it must hold reserves to be able to lend and it must get those reserves somewhere. To maintain the entitlement to lend (as you put it), it must find marginable reserves.

Maybe I made the widget myself. Does it matter?

Yes. Your labour is worth something and you probably had to buy materials to make the widgets. Even if a widget is defined as a poem you wrote, it still has value because I've just parted with $100 for it and you decided it was worth your time to create, so the alternative uses of your time to be less valuable.

This is credit. Credit doesn't require you to borrow money from me or anyone else before the transaction. It only requires me to obtain money after the transaction. I understand your objection to this formulation, but the objection is only semantic.

That's my point, Martin. The difference is certainly NOT merely semantic. I think you're confusing explicit borrowing from, say, my friend Jane to pay for the widget and implicitly borrowing from you because you accepted payment in the future. Although, I'm not sure why you're having such a hard time seeing that the two are the same thing.

The point is that you haven't borrowed money from me or anyone else. Neither one of us must possess $100 before the transaction. We might both have popped into existence along with widget an instant before.

Martin, you're making an elementary mistake here that I'm pretty sure you don't make in your real life decisions. Let me think about how to explain this better and get back to you (it's late and the brain is creaky right now).

Borrowing is cheaper than raising equity, so the margin is much higher.

I don't know why this is true, except that bankruptcy courts order bondholders paid before equity holders. It's just a matter of statutory authority, because the state orders priorities this way. Why else would it be true?

Even if the firm never goes into bankruptcy, bond holders must be paid at regular intervals and before common shareholders. Debt service appears in the expenses portion of an income statement. The income left for common shareholders is whatever is left over after everyone else gets paid – hence, a shareholder is a residual owner of the company. Because they are the last in line, shareholders bear the most risk and require a higher rate of return to compensate for that risk. Thus, a company may float a bond issue with a 6% coupon but the same company will not be able to raise equity capital unless it can convince potential buyers of the equity that the expected return will be 10%. Of course, all of these rules are set by some statutory authority.

Certainly, a reserve requirement is only one possible regulation. Others seem advisable. I'm definitely not an anarchist here.

Regulation isn't going to fix stupidity, greed, and hubris. Only the threat of failure will mitigate those instincts. The regulators are offering a bailout and threatening regulation. Regulation which will be swiftly circumvented or changed to create more rents for lenders. My observation from working for a long time in a highly regulated industry is that regulation favours those being regulated and at the expense of the customers.

You don't borrow money from me to buy the widget. You borrow the widget from me.

No, I'm not borrowing the widget. You don't expect the widget to be returned to you. You expect money to flow to you over time in exchange for the widget. For the time that I have the widget but you have not yet received all the money, I have implicitly borrowed the money from you.

We don't put money to productive use as much as money accounts for things we put to productive use. I put the widget to productive use by lending it to you.

First of all, you're not lending the widget. Second, how are you putting the widget to productive use by selling it to me on credit? Why is selling me the widget on credit more appealing to you than receiving the full price of the widget at the point of sale? If it is not more appealing, then how are you being compensated for choosing the less appealing option to make you indifferent between the two options?

The point is that we don't need money for this purpose. We can imagine money if we like.

Let's assume that money represents our individual production. So, instead of directly exchanging the goods I produce for your widget, assume I give you much more easy to handle paper bills which represent my production. So, we're bartering, but paper currency represents my production, which I'm exchanging for yours (the widget). To make things easier, let's assume that this is what we mean by "money".

No, it does happen routinely. It happens every day. Our inflation rate doesn't rival Zimbabwe's, because we don't create money as rapidly, but we do create it continuously.

I agree with that. I thought you meant that the Fed routinely prints money without regard to actual productivity. That happens, but not routinely.

CD's are FDIC insured like deposits. The reason they earn a slightly higher interest rate is to compensate the lender for the lock-up (deposits have no lock-up, of course). FDIC creates distortions in the risk, but even with FDIC, the CD holder risks the opportunity cost of rising interest rates.

But he doesn't risk loss of the deposit. He suffers no nominal risk at all, i.e. he knows precisely the numeric value of his return with practical certainty. That's the whole point. Only a statutory system can promise this certainty. These nominally riskless investments are not free market capitalism.

If interest rates rise during the lock-up, the CD holder will lose the difference between the current interest rate and the one he is receiving for his CD.

Why would the nominally riskless interest rate for a term less than six month rise? The Fed effectively regulates this rate through open market operations, so the rate rises at the Fed's command. It's true that you don't now what the Fed will do, but your uncertainty doesn't imply a free market. No one knew what Mussolini or Stalin would do either.

Or it's a cry to stop printing money like the Weimar Republic.

It can be that too.

The real value of assets can appreciate or depreciate.

Real assets can appreciate, but money is an accounting device rather than a real asset. It accounts for the holder's entitlement to consume. When you hold money, you're playing an entitlement game with monetary authorities, and this game is like the market only insofar as monetary authorities construct the game this way.

This represents a real loss of value.

It's a real loss of entitlement to consume, compared with the entitlement that might be earned otherwise. All games have rules, but calling this game "free market capitalism" is an Orwellian abuse of the language. In free market capitalism, a player holds real assets for their productive utility, not documentary evidence of some central authority's guarantee of a nominal yield.

Banks do accept deposits to lend them. The fact that banks leverage their loans doesn't change that.

If the reserve ratio is 10-1, a bank with only one dollar on deposit may lend nine dollars. It may not lend ten dollars, only nine. That the bank nominally "borrows" the other nine dollars from the rest of the banking system, including the central bank, hardly matters. The central bank ultimately creates all of these dollars in order to lend them, hopefully secured by real assets and a real demand for credit, and the central bank essentially destroys the dollars as member banks repay its loans.

In principle, individual banks could do the same without a central bank. The central bank is only a regulatory authority presumably preventing individual banks from creating money excessively by setting reserve requirements among other things. If the gold nuts only understood this fact, I'd have less of a problem with a gold standard, but a gold standard does not avoid fractional reserve banking. It only fixes the price of gold.

If I deposit a dollar in a bank, does the bank ever lend my dollar specifically? All dollars are interchangable, so this question is meaningless; however, with a reserve requirement, a bank must hold some dollar in reserve to satisfy depositors including me. We might as well say that the bank never lends my dollar but only holds it to maintain an entitlement to lend other dollars. This formulation of the entitlement is equivalent.

And how did you pay for the widget you're now selling to me on credit?

Maybe I made the widget myself. Does it matter? The point is that I own the widget before I transfer it to you with only an expectation of payment over time. This is credit. Credit doesn't require you to borrow money from me or anyone else before the transaction. It only requires me to obtain money after the transaction. I understand your objection to this formulation, but the objection is only semantic.

Incidentally, are you really going to lend me the $100 for 10 weeks at a zero interest rate or is the interest rate built into the price already?

The interest is not relevant to my point. I'm happy to charge you ten dollars and dime weekly for ten weeks. The dime compensates me for the risk that you'll not pay me.

I have borrowed the $100 from you in a very literal sense and the only thing backing that loan is my future production and the widget.

You have borrowed the widget from me, and the widget is worth ten dollars. I have no problem with this formulation. More precisely, "ten dollars" names the value of the widget in common parlance (the language we agree upon in the market).

The point is that you haven't borrowed money from me or anyone else. Neither one of us must possess $100 before the transaction. We might both have popped into existence along with widget an instant before.

Banks do borrow at the short end of the curve and lend at the long end.

But the borrow is not necessary to extend credit. Banks needn't borrow (accept deposits) to extend credit at all, and in some banking systems, they don't. Some banking systems have no reserve requirement. In principle, you could open a bank, fetch some newly created money from the monetary authority and immediately start lending it. The monetary authority avoids creating too much money this way, hopefully, because that's just his job. He's a state regulatory agent.

Borrowing is cheaper than raising equity, so the margin is much higher.

I don't know why this is true, except that bankruptcy courts order bondholders paid before equity holders. It's just a matter of statutory authority, because the state orders priorities this way. Why else would it be true?

Of course, so is the risk of so much leverage – which is why it's particularly unwise to loosen lending standards as much as they were loosened in the past few years.

Certainly, a reserve requirement is only one possible regulation. Others seem advisable. I'm definitely not an anarchist here.

"Borrowing" is something else really. This word suggests that I take possession of something of real value today and exchange it for your widget today.

No, I'm borrowing from you to buy the widget. I'm taking possession of your widget today (which has value) and I'm paying your for the widget over time.

You don't borrow money from me to buy the widget. You borrow the widget from me. I say this myself. You obtain the value of the widget in some other form to compensate me later. You don't borrow the value of the widget to exchange this borrowed value for my valuable widget at the point of sale. You only provide me the value of the widget over time after the exchange. That's credit.

If I had paid you the $100 today, you could have reinvested it in inventory, or put it toward other productive use.

We don't put money to productive use as much as money accounts for things we put to productive use. I put the widget to productive use by lending it to you. Perhaps, I expect you to put the widget to productive use to earn its price. I don't need money for this purpose. I need the widget.

The point is that we don't need money for this purpose. We can imagine money if we like. This imaginary money is like the money that monetary authorities circulate. That's my point.

Your opportunity cost of lending me the $100 has real value to you.

I don't lend you $100. I lend you a widget. You and I agree to name the value of this widget "$100". I enter this name in my accounting ledger.

If you want to agree that my accounting entry is money, that's fine. I'll agree. Money is an accounting device, like so many entries in a ledger. That's my point.

The only difference in your widget scenario and what you describe as "borrowing" is who is doing the lending. Otherwise, they are exactly the same.

That the scenarios are essentially the same is precisely my point. If we agree that I've lent you $100, then I might as well be the author of this money myself. I am the monetary authority. If another monetary authority will then exchange its notes for my accounts receivable (or lend me its money with my accounts receivable as collateral), then I may exchange my money for this other money. Anyone may create money this way.

True enough. There's nothing to stop government from printing money. However, you simply can't say this is what happens routinely. If it did, our inflation rate would start to rival Zimbabwe's. This is starting to smell of the gold standard argument. Is this where you're going?

No, it does happen routinely. It happens every day. Our inflation rate doesn't rival Zimbabwe's, because we don't create money as rapidly, but we do create it continuously. We also destroy it continuously.

This is starting to smell of the gold standard argument. Is this where you're going?

No. Vidyohs will tell you that I'm no champion of what people commonly imagine as "the gold standard". Money is not a commodity. It's an accounting device. A gold standard only fixes the price of gold and requires decentralized monetary authorities to bank gold and trade it at this fixed price. A gold standard does not dictate how much money the authorities may circulate. It implies no one-to-one correspondence between banked gold and bank notes redeemable in gold. It only requires gold bankers to redeem notes for gold at the established price.

Sorry, Martin, but reading that statement one more time doesn't help me understand why the analogy is not valid.

"Not valid" is your description. Mine was "highly debatable" The analogy is debatable, because China's economy is potentially much, much larger than Japan's. I don't know how to make such an obvious point except simply to state it. You think this difference between Japan and China is irrelevant?

China with the same per capita productivity as Japan produces ten times a much. China with the same per acre productivity produces twenty-five times as much. These measures are crude, but I only suppose that, with a similar rule of law, China easily could be a far larger economy than Japan. Ignoring such an obvious distinction is obtuse.

I'll say more later. Be patient. I don't oppose trade with China. If it were up to me, there would be far fewer restraints on trade with China, including fewer restraints the purchase of goods allegedly infringing intellectual property claimed within the U.S. and fewer restraints on Chinese labor within the U.S. (fewer restraints on immigration).

Sorry, Martin, but reading that statement one more time doesn't help me understand why the analogy is not valid.

Adrian Chiew related the 1980's fear of Japan to the current fear of China. You claim that analogy is debatable, but only offer some reference to the differences in size of the populations. Why does the population make any difference?

Some 1980's protectionists were fearful of Japan's economic growth. Some current protectionists are fearful of China's economic growth. What's debatable about that?

Please don't repeat the sentence about China's population being so much larger without some explanation as to why that's relevant to Adrian's point.

Frank Rich has a hobgoblin that he is trying to build.

So what are you saying, Martin?

I'm saying the analogy is debatable because Japan has half the U.S. population on an island the size of California while China has four and a half times the U.S. population in a region the size of the U.S.

So what are you saying, Martin? That China's economic advance is a threat because its population is five times that of the U.S.

The answer depends on who you are and what you consider threatening. The problem, if any exists, is not China's advancing productivity. In the U.S. civil war, freer labor in the North objected to competition with slave labor in the South, with some justification. Also, globalization is not exclusively, or even primarily, about freer trade. International patents, for example, do not constitute freer trade. They are global, forcible monopolies.

Do you disagree with it?

I haven't read your post. I'll say more later.

…That was meant as comedy wasn’t it?

…Please tell me that it was satire, please.

…Was this for the John Stewart show, or maybe the Cobert report?

…No!

…This guy gets published in the NY Times! Maybe things are worse than I thought.

Why? We were talking about how fear of China's economic growth today makes no more sense than did fear of Japan's economic growth 20 years ago.

Martin Brock: "China has five times the U.S. population in a region the size of the U.S."

So what are you saying, Martin? That China's economic advance is a threat because its population is five times that of the U.S. If so, please explain how China joining the ranks of the developed nations would be a threat to the U.S.

I've staked out my position in post from earlier this morning. Do you disagree with it?

Not meaning to be nitpicky, but the population of China is 4.38 times the U.S. population of 301 million.

Real capital offers no guaranteed yield or even a minimum yield. You may lose all or part of your investment, precisely because the market is free.

CD's are FDIC insured like deposits. The reason they earn a slightly higher interest rate is to compensate the lender for the lock-up (deposits have no lock-up, of course). FDIC creates distortions in the risk, but even with FDIC, the CD holder risks the opportunity cost of rising interest rates. If interest rates rise during the lock-up, the CD holder will lose the difference between the current interest rate and the one he is receiving for his CD. This represents a real loss of value.

In a fractional reserve system, banks accept deposits only to maintain an entitlement to extend monetary credit that is a multiple of deposits held. They don't accept deposits to lend them. The deposits only play a regulatory role in the system. Banks routinely extend credit far exceeding their deposits.

Banks do accept deposits to lend them. The fact that banks leverage their loans doesn't change that.

Short term borrowing isn't necessary to extend credit, and most long term credit is not borrowed short term. It isn't "borrowed" at all in a literal sense. You walk into my store and walk out with a widget worth $100, but you don't leave me with $100, because I agree to accept ten dollars per week for ten weeks instead.

And how did you pay for the widget you're now selling to me on credit? Incidentally, are you really going to lend me the $100 for 10 weeks at a zero interest rate or is the interest rate built into the price already? I have borrowed the $100 from you in a very literal sense and the only thing backing that loan is my future production and the widget.

Banks do borrow at the short end of the curve and lend at the long end. This is otherwise known as the "carry" or "curve" trade and "works" because most of the time the interest rate curve is upward sloping. Borrowing is cheaper than raising equity, so the margin is much higher. Of course, so is the risk of so much leverage – which is why it's particularly unwise to loosen lending standards as much as they were loosened in the past few years.

"Borrowing" is something else really. This word suggests that I take possession of something of real value today and exchange it for your widget today.

No, I'm borrowing from you to buy the widget. I'm taking possession of your widget today (which has value) and I'm paying your for the widget over time. If I had paid you the $100 today, you could have reinvested it in inventory, or put it toward other productive use. Your opportunity cost of lending me the $100 has real value to you. The only difference in your widget scenario and what you describe as "borrowing" is who is doing the lending. Otherwise, they are exactly the same.

That's just not what happens when I "borrow" money from a bank to make the purchase, not necessarily anyway. Monetary authorities can and routinely do simply create this money from nothing. Only my future productivity secures the "loan". The only real capital involved is my own future labor or the future value of other assets I possess.

True enough. There's nothing to stop government from printing money. However, you simply can't say this is what happens routinely. If it did, our inflation rate would start to rival Zimbabwe's. This is starting to smell of the gold standard argument. Is this where you're going?

China is catching up fast to the size of the economy of the US, EU and Japan, but the closer they get the harder it will be to maintain that growth.

The real reason behind the successful economic growth of China isn't their government's superior economic policy to the US government. It's because they're coming from such a low base, that means achieving high economic growth is far easier.

That may be true of a house or of commodities, but it may not be true of other assets with "real value" such as stocks or bonds.

Using "real value" in a technical sense, it's practically true by definition. If your asset doesn't hold its value, relative to other things, as prices generally rise, then the value isn't "real". It's only "nominal".

Often, when people cry for government to "stop inflation", they're really crying for government to guarantee them a real yield, but the real value of an asset can depreciate and typically does. If you don't want money losing value in a bank account, take a risk and hold something else. No state policy creates this necessity, and no state policy should try to prevent it.

I'll give you T-bills (we agree that treasury issues are merely a tax), but why aren't other short term investments "real capital"?

I included CDs, because banks often back CDs with Treasury securities, but a CD can be related to real credit.

If you extend credit to organize resources productively, and if the productive organization repays the credit from value added in a free market, that's real "capital", but this capital is always risky. Real capital offers no guaranteed yield or even a minimum yield. You may lose all or part of your investment, precisely because the market is free.

Nominal "capitalists" often are the greatest enemies of a free market for this reason. The Bushniks illustrate this point resoundingly. They adore the state. They want nothing more than reams of new Treasury notes. They don't sell notes to wage war. They wage war to sell notes. Selling entitlement to tax revenue is an end in itself.

The bread and butter of banking business is borrowing at the short end of the curve and lending at the long end.

In a fractional reserve system, banks accept deposits only to maintain an entitlement to extend monetary credit that is a multiple of deposits held. They don't accept deposits to lend them. The deposits only play a regulatory role in the system. Banks routinely extend credit far exceeding their deposits.

Without short term borrowing, what will banks lend for people to buy houses and finance business ventures?

Short term borrowing isn't necessary to extend credit, and most long term credit is not borrowed short term. It isn't "borrowed" at all in a literal sense. You walk into my store and walk out with a widget worth $100, but you don't leave me with $100, because I agree to accept ten dollars per week for ten weeks instead. That's credit. I accept your credit in lieu of immediate payment, because I expect you to pay me from value that possibly doesn't exist at all at the time of the transaction, value you produce only later.

"Borrowing" is something else really. This word suggests that I take possession of something of real value today and exchange it for your widget today. That's just not what happens when I "borrow" money from a bank to make the purchase, not necessarily anyway. Monetary authorities can and routinely do simply create this money from nothing. Only my future productivity secures the "loan". The only real capital involved is my own future labor or the future value of other assets I possess.

I'm not sure what you are meaning. Are you saying that China will never "overtake" the U.S.? What does that mean?

If Chinese per capita GDP ever reached the level of U.S. per capita GDP, that would be a wonderful miracle for the entire world. Of course, China has a population 4 times the size of the U.S., so its GDP would then be 4 times that of the U.S. How would that be a bad thing?

If the GDP per capita of every nation equaled that of the U.S., just think how many research scientists and inventors and entrepreneurs could be employed solving mankind's problems. We can only dream about how much better the world would be if China did "overtake" the U.S. Or if India did as well.

We do not live in a zero sum world. We do not lose when other nations progress economically. In fact, every developed nation will benefit from the economic progress of developing nations. Unless, of course, the U.S. protectionists who are damned determined to hurt U.S. consumers get their way.

Or, as a friend put it, Wall Street firms benefit from volume, and once their bonuses are paid, they could care less what happens, because it's the actual stakeholders who lose from malinvestment.

Do you not see this as a legitimate explanation of the recent trend of financial bonuses at investment banks and other financial services firms?

Jonathan,

There's a lot of truth to that. It's the trader's option – the incentive to sell far out of the money options. You collect your premium most of the time, until you run into the one time when you blow up (then you go launch a $6 billion hedge fund and proceed to lose that too).

This is blow up time. A colleague at an I-Bank which I won't name but is famously desperately seeking a buyer, lost ten years of compensation as the firm's stock tanked over the past year. Recently, more and more (sometimes a majority) of Wall Street compensation is not cash but stock in the company for which you work and it's deferred, vesting over a period of years. This has been the trend over the past 5-10 years. Much of the compensation comes in the stock of the company they work for. This can also be true for the portfolio managers of hedge funds.

The papers reported 2007 as a record Wall Street bonus year. What they didn't report is that a very large percentage of those bonuses were rescinded. CDO departments largely didn't pay bonuses at all (and fired employees) and a lot of employees received as little as 10% of their expected compensation if any bonus at all. Base salaries usually range from $100K to $200K in a city where we have the highest tax rates in the country and the average apartment sells for over $1.5 million and is tiny compared to anything outside the city.

Hubris and degenerate gambling are still large problems on Wall Street and always will be, but steps have been made to align risk and reward for Wall Streeters. They can no longer receive the bonus and not care what happens next.

That may be true of a house or of commodities, but it may not be true of other assets with "real value" such as stocks or bonds.

Money in a bank account (or a CD or a T-Bill) is not what I call "real capital" anyway – Martin

I'll give you T-bills (we agree that treasury issues are merely a tax), but why aren't other short term investments "real capital"? The bread and butter of banking business is borrowing at the short end of the curve and lending at the long end. Without short term borrowing, what will banks lend for people to buy houses and finance business ventures?

I generally agree with what you're saying. However, the amount we throw at the "warfare state" pales in comparison to how much we throw at the welfare state and how much that spending is forecast to grow relative to defense spending. I understand you don't approve of the Iraq war and other entanglements, but you needn't blow it out of proportion to make your point. The last time I checked, we were still the most productive country, so I don't know why you think that we're not producing anything anyone wants to consume. Although, the housing subsidies that government keeps dreaming up (as one example: removing capital gains tax entirely from housing but not from other investments) have played a role in the inefficient allocation of assets known as the recent housing bubble.

I heard that you quit a lucrative career on Wallstreet to get involved in the political campaign of Ron Paul. Is that true? Why did you do it?

A country's most valuable resource is its people.

You need to stop seeing people as resources and start seeing them as individuals. Human beings are not like Oil or Copper or Sheep. Central planning the optimization of human productivity is what a fascist would do.