Thursday, May 20, 2010

Imagine There's No Credit Market: Another Look At German Controls

Imagine there's no credit market
It's easy if your try
John Lennon (if he'd lived long enough)

[Money] is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. J.S Mill

Centuries ago there were these things called markets. At the end of a harvest farmers would take their produce to a common area and (hopefully) exchange their goods for other goods or money. In some cities remnants of this history still exist, like civil war battle re-enactments. We call some of these "farmer's markets".

Over time, the word, "market" was applied to any process wherein people exchanged things, even if there was no designated place to meet and most of the exchanges were done by proxy. Thus we use phrases like "credit markets", for instance, which, unlike today's farmer's markets, don't exist. There is no common place to go when one has savings one wishes to lend to meet up with borrowers and haggle over terms.

If I told some friends the financial capital of the nation was allocated in Narnia, Middle Earth or Hades, they might think I needed some time in a rubber room. Yet I could tell the same people the financial capital of the nation is allocated in credit markets, and seem wise despite the fact that Narnia and credit markets are both simply mental constructs. They don't exist.

One of Ludwig von Mises' great contributions to Economics was his focus on human action as the quantum of economics. Aggregates (like GDP), averages (like median income), and credit markets (like the US bond market) are mental constructs, nothing more. When people talk about the US economy, for instance, they are talking about an idea, for such a thing does not exist.

We, humans, exist (sidestepping valid, but for our purposes, irrelevant philosophical issues). We live, breathe, eat, sleep and act, and in so doing, we change the world, which also exists, and are changed by it. This idea we call "an economy" is a construct we imagine to be composed of the actions of millions of people, making, working, buying, selling, and saving.

Confusion over this key point is rife. Politicians talk about saving the economy and speculators talk about freeing the markets, but neither exists to be saved or freed.  People all over the world think their investments are worth what a bunch of intermediaries say it is worth, instead of what it eventually returns.

A general sense is seemingly shared by many- when an aggregate measure (GDP) expressed in currency, mind you, not tons of steel, bushels of wheat, etc. of a non-existent construct (the US economy) rises, times are thought to be good. It seems to me, however, there is no time but our time, lived individually, not collectively. The economy to each of us is the sum of our actions conditioned by the sum of all others'.

I had the above points in mind while devising yesterday's model of a grain market with speculators. Instead of conceiving of it as a motion picture- a series of frames projected faster than the human eye samples, thus creating an illusion of continuous motion, or reality- I focused on the frames, which, in the case of markets, are transactions or exchanges.

I wrote that the model could be used for any exchange and as I've gotten some requests, here's the model applied to monetary exchanges, what we call credit markets.

As in our grain market model, there are producers, consumers and middle-men. Producers have money, consumers want money, and the middle-men bring the two together. The producers lend their money to consumers in hopes of future repayment plus some profit, what we call interest. As in our grain market model, profits are allocated based on individual transactions. Usually producers lend their money to middle-men who, in turn, lend it to consumers.

Let's imagine a farmer who had such a bumper crop he ended up with 2000 pieces of silver. Let's imagine a town administrator who wished to borrow 2000 pieces of silver to pay workers to build a bridge over a nearby river and thus increase tax revenue during the local market season. The administrator bets he can collect an extra 2100 pieces of silver during next year's harvest market.

In a small town, the administrator might visit the farmer and agree to borrow his silver and repay it next year plus 100 pieces in interest (not a bad deal as the taxes would be collected each year the bridge was still working). In a larger town, the farmer might bring his money to a bank, and the banker might lend it to the administrator and take, say, 30 pieces of silver for his trouble.

As in our grain market model, the middle-man/banker doesn't increase the total profit of the transaction, nor does he decrease the risk the bridge won't be completed and tax revenues won't be collected. If the administrator defaults on his obligation, the banker is still obliged to repay the farmer, from his own pocket, if need be, or he goes out of business (unless, of course, he's a TBTF banker who gets government to impose an additional tax on citizens to pay for his errors in judgment).

In the above model, the banker provides "liquidity" to the farmer, borrowing his money at a rate somewhat lower than he believes he can lend it to the administrator. Today, hordes of commercial paper and bond traders do exactly the same thing. Perversely, their liquidity providing actions, as they trade with each other waiting for a new producer with money to lend, or consumer, wanting to borrow it, has come to be called "credit markets" when real credit market action only occurs when new money is lent.

Thus, when people speak of "rescuing the credit markets" they really mean to say rescuing the liquidity providers who failed to assess lending risks so profoundly they can't make required payments. When people talk of German restrictions killing the credit markets, they really mean killing the middle-men (which may or may not have a deleterious effect on government borrowing).

German restrictions on certain types of equity and credit transactions are not aimed at reduced government borrowing. They are aimed at reducing the amount (and means of capture) of profit "earned" by middle-men in the transaction- profits, mind you, as per our model, in the case of government borrowing, come either as a result of the money's original owner getting less interest than a direct deal would generate, the government paying more interest (which only comes from higher tax revenues) than a direct deal would generate, or some combination thereof.

Like all markets, credit markets create nothing (which I suspect, is a big problem with naked CDS, from whence do the profits come in the event of default?), they merely distribute.  As per J.S. Mill, their purpose is increased efficiency of a task that would otherwise occur.

If all of the TBTF banks were put of business tomorrow by government decree, and forced to distribute whatever capital and deposits they could, there would still be people with money willing to lend, and borrowers willing to borrow (most likely at rates far higher than are apparent today).

Some might argue such would be the end of the credit markets, which, leaving aside debate over the termination of a figment of one's imagination, might not be such a bad thing.

Let's play along with John Lennon and imagine no market for government bonds. Let's imagine a government, like mine in the US, which, instead of announcing an auction of $113B in 2-year notes to be mediated by direct dealers (there's a neat contradiction in terms) simply lists its borrowing needs and potential terms on an internet site, which willing borrowers could view and perhaps post their desired terms. These days, an auction program could perform most of the same functions the direct dealers do- putting together sellers and buyers- at a small fraction of the

There are, of course, some things auction programs can't do, like sell toxic debt at low rates to unsuspecting people, but we might not really miss that.

Some eager bond traders would likely argue the above scenario would lead to more volatile interest rates. I agree. Prices of exchanges like the above would be much more responsive to current events. Countries like Greece would have gotten a much earlier warning of trouble ahead, which, in hindsight, seems a good thing.

In sum, liquidity providing actions of "credit market" middle-men has run amok. As per J.S. Mill, that credit markets are exerting a distinct and independent influence of their own means they are out of order. With increasing frequency, credit is mispriced or unwisely extended and liquidity, the raison d'ĂȘtre of these people, dries up when it is needed most. Yet the middle-men who fail in their tasks expect to be rescued from their failures, and given even more ways to profit from lending other people's money, while the pool of available savings shrinks.


p.s. In one sense I'm quite happy about all of the financial sector bail-outs governments have provided these credit-market middle-men. Before the bail-outs, one had to argue that finance was like a tax on monetary exchange, now this point is clear, finance is, in fact, a tax- and a growing one at that.


SimpleTrader said...

Hey Dude, Just discovered your excellent blog a couple of days ago (thanks to Jesse at Crossroadscafe).

I find myself in total agreement with what you say, almost as if I would have written the same thoughts if I had the time and the bandwidth; except of course that mine would not be so lucid and fun to read. I too would describe myself as a philosopher first and an engineer / businessman second.

It is a shame that such excellent analyses of vitally important matters, which affect the fate of each individual and every nation, are ignored by those that have the power to do something. Probably it goes in their 'too hard' basket. I've sadly come to the conclusion that this is human nature ... nothing anyone can do to change that.

Where are you based, and what do you do for a living?
Keep the good stuff coming!
Pandu (

Dude said...


Glad you enjoy my musings.

As you intimate, it's often easier to ignore wisdom until necessity strips the blinders from one's eyes.

I agree. It's human nature.

ZetaEx said...

Its the nature of all humans but the ambition of SOME.

Yes, SOME humans will destroy their neighbor in pursuit of their insatiable ambition.

But, some humans learn from their mistakes, and through hard work save for a rainy day.

Some humans have the interest of their neighbor as well as their own at heart, and take joy in the success, personal and professional, of others.

The fight will never end to promote the wise over the foolish, but we must never tire in the effort or the work. Such is our lot, and the mandate of our stewardship over what liberty remains to be had in this world.

Till Armageddon come to pass, Seek Justice, Love Mercy, and walk humbly with your God.

Rob said...

I really loved this post. I wish I could write one tenth as well as that.

The big lebowski is also one of my favourite films too - a perfect combination!


SimpleTrader said...

Hey Dude,
Can you perhaps write a thought experiment on how practical it is, in today's world, for any country to move to a gold backed currency? For argument's sake, lets say Switzerland, or Germany, or China, were to adopt a gold backed currency. How would it affect international trade? Exchange rates? Gold prices in various currencies? How would it affect said country's own economy? Is there enough gold in the world for today's 1000s trillion $ economy? Is it feasible?

Nicholas said...

Hey Dude,

Also just found your blog here a couple days ago, I really enjoy your writing style and approach. So far, very easy to understand for a non-economist/finance guy like me.

Dude said...


I hope others can imagine alternate paths that lead to "harder money" because all those I imagine include a great deal of pain and likely involve the loss of being issuer of the world's reserve currency (which might well be a good thing in the long run).

Dude said...

Rob and Nicholas,

I'm glad you enjoy my musings.