If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Wednesday, 31 March 2010

From rags to riches

Recently a post (see below this short article) can be found on numerous blogs: a "from rags to riches" recipe. If it worked, we could all make, on average, $11,390,625 ($1 x 156). The whole world would become rich! (Just rich, not fabulously rich.) The financial crisis would be irrelevant. Wouldn't it be great?

But for the same (technical) reasons as the credit crunch happened, the "from rags to riches" recipe will not make us rich. It will fail miserably. Like the causes of the current financial crisis, it is yet another example of a pyramid scheme.

You've been warned.


Hi guys/gals,

This is the real thing $6 PayPal fast Cash in few Weeks
FAST CASH $6 PAYPAL as seen on OPRAH and 20/20

Since things went in the tanks with the recession, business has been slow and I have been paying my bills with income from working this system. I am going to show it to everyone I can since it was shown to me and it was invented to be shared amongst the struggling masses.

READ THIS, FOLLOW THE INSTRUCTIONS, PASS IT ON if you would like to make THOUSANDS OF DOLLARS and make your financial dreams come true with only a $6 investment!

There is no limit on how much money you can receive, and you haven't got anything to lose with this Business program. It's simple and it's safe.

!!!!!!QUICK MONEY!!!!!! -- FAST CASH

At first I thought this was too good to be true...how wrong I was!! I decided to give it a go, it was only 6 dollars, so why not? Well I was astounded!! Money has been, and still is, coming to my account. **Proven by various, highly respected U.S. TV and Radio programs as being 100% legal, feasible and true. ** Oprah Winfrey and ABC's investigation team 20/20 also proved it can be done.

This is all you need:

1) An email address
2) A Pay Pal account
3) Then POST, POST, POST..........

Ever since the internet became popular, the word "scam" has become a daily term. I have never once tried any moneymaking "system" outside of this because of that very reason. However, after reading reports on the validity and reputation of this money making system (seen on Oprah, CNN, and other media forums) I gave it a try. Only hours after implementing this exact system I just about fell out of my chair as money ACTUALLY started rolling in. I couldn't believe it and for that reason, I became a believer in this system.

There is a list of 6 email addresses (you'll see it as you read further). Each of these people has already taken part in this system. When someone new comes along (such as yourself) he/she removes #1 off of the list, moves the other five email addresses up one position (i.e. #6 goes to #5, #5 to #4, etc.), and adds their Pay Pal email address in the 6 position. This process is what develops the power of compounding. The bottom line is this... Honesty and Integrity creates Profitability. Following this EXACT process is what creates the money, and that is why this system has been raved about. Altering the system creates weak results. The legality of this system comes from the idea that you are of course creating a mailing list, and a "service" is being provided (more on that later.)


The first thing to do COPY, PASTE and SAVE this entire post in word or notepad on your computer so you can come back to it later. After that, if you are not already a Pay Pal user you need to go to the Pay Pal website at https://www.paypal.com/ and SIGN UP. To receive credit card payments from other people you must sign up for a PREMIER or BUSINESS account (not just a PERSONAL account). This is highly recommended to allow others easy payment options. To place the initial $6 into your account, you will have to verify your bank account with PAYPAL (which may take a few days). PAYPAL is 100% secure and is used by millions of people worldwide.

Here is where the action occurs. Next send a $1.00 payment to each of the 6 email addresses on the current list from your Pay Pal account. To do this quickly and successfully, follow these simple steps:

1. Login to Pay Pal and click the "Send Money" tab near top of screen
2. In the "Recipient's Email" field type: the email address
3. In the "Amount" field type: "1" (your $1.00 payment)
4. In the "Category" field select: "Service" (Keeping it legal)
5. In the "subject" field type: "EMAIL LIST",
6. In the "message" field type: "PLEASE PUT ME ON YOUR EMAIL LIST". (By doing this, you are creating a service and maintaining the legality of the system by "paying" for the service.)
7. Finally, click on the "Continue" button to complete the payment.
8. Repeat these steps for each of the 6 email addresses.

That's it! (By sending the $1.00 payment to each address, you are implementing the compounding POWER of the system. You will reap what you sow!)

Here is the current e-mail list:
The email list:

1) [1]@gmail.com
2) [2]@gmail.com
3) [3]@gmail.com
4) [4]@gmail.com
5) [5]@gmail.com
6) [6]@gmail.com


Now take the 1 email off of the list that you see above (from your saved file), move the other addresses up (6 becomes 5, 5 becomes 4, etc.) and add YOUR email address (the one used for your Pay Pal account) as number 6 on the list. This is the only part of the document that should be changed. **Make sure to use the email address you registered with Pay Pal**

now post new file created in STEP 3 to at least 200 newsgroups or message boards. Keep in mind that there are tens of thousands of groups online! All you need is 200, but remember the more you post the more money you make as well as everyone else on the list!
Use Netscape, Internet Explorer, Fire fox, Safari, or whatever your internet browser is to search for various news groups, on-line forums, message boards, bulletin boards, chat sites, discussions, discussion groups, on-line communities, etc.

For example? Log on to any search engine like Yahoo.com or Google.com and type in a subject like 'MILLIONAIRE MESSAGE BOARD', MONEY MAKING DISCUSSIONS', 'MONEY MAKING FORUMS', or 'BUSINESS MESSAGE BOARD', etc. You will find thousands and thousands of message boards. Click them one by one and you will find the option to post a new message. Fill in the subject, which will be the header that everyone sees as they scroll through the list of postings in a particular group, and post the article with the NEW list of email addresses included. THAT'S IT!!! All you have to do is jump to different newsgroups and post away. After you get the hang of it, it will take about 60 seconds for each newsgroup.

When you post 200 messages in various forums, it is estimated that at LEAST 15 people will respond and send you a $1.00 ($15.00). Those 15 will Post 200 Posts each and 225 people send you $1.00 ($225.00), etc. through 6 levels of email addresses. For comprehension purposes, here is an easy viewing chart:

1) 15(1) = 15 people ($1) = $15
2) 15(15) = 225 people ($1) = $225
3) 15(225) = 3375 people ($1) = $3,375
4) 15(3375) = 50625 people ($1) = $50,625
5) 15(50625) = 759375 people ($1) = $759,375

Within a few WEEKS you begin to see results, thanks to the speed of the internet! When your name is no longer on the list, take the latest posting in the newsgroups and begin the process again. Simply amazing...Follow the system as described, and enjoy your PROFITS!!!


Remember that most news servers will leave the posted messages on there servers for about 2 weeks. If you will post your message again, it WILL again start from the beginning. So you can repeat this over and over again. There are tons of new honest users and new honest people who are joining the Internet and newsgroups everyday and are willing to give it a try. Estimates are at 20,000 to 50,000 new users of the Internet, every day.
!!!!! REMEMBER!!!!! Follow every step, and IT WILL WORK!!!

Make Today A Great Day. Wish U Well...

Monday, 22 March 2010

Computational complexity analysis of Credit Creation

This article presents a rigorous analysis of many issues discussed on this blog already sometimes in a less formal manner. Especially a banking practice of lending with Loan to Deposit Ratio above 100% that has been shown to constitute a sufficient condition of causing liquidity shortage in the banking system (i.e. it was a sufficient condition that caused the current financial crisis).

It is estimated that Cash (narrow money) constitutes around 2% of money circulation in the economy. The reminder 98%, sometimes referred to as broad money, is created by banks through Deposit – Loan Cycles. It is called Credit Creation. When money is paid into a Bank it is


  • a disbursement (cost) that a Bank has to pay out (but even, in this case, unless it is stored privately, it will end up in a Bank as someone else’s Deposit); a dividend to be paid by a Bank to its shareholders is also considered as a disbursement

  • a Deposit; any other money than disbursement is considered as a Deposit paid into a Bank (e.g. if it is a Bank’s retained profit, Bank’s own money is a Bank’s Deposit on its own books; if a Bank uses its own money to buy an investment product, from Deposit – Loan Cycle perspective, in this model it is considered as if a Bank was lending money to itself).
A Bank can lend out Cash that is paid in as a Deposit: this is Credit Creation.

A liquidity risk is a risk of a situation when a demand made by a Depositor to withdraw Cash (narrow money) cannot be met by a Bank. If Money Multiplier is 1 (or less) liquidity risk is 0%: $1 (or more) Cash Reserves covers every $1 Deposits on a Bank’s Loan/Deposit Balance Sheet. If Money Multiplier tends to infinity liquidity risk is 100% in a finite time: at the limit, $1 Cash would have to cover infinite amount of dollars of Deposits on a Bank’s Loan/Deposit Balance Sheet.

Liquidity risk is directly associated with a phenomenon called “bank run”, when depositors, in large numbers, would like to withdraw money from a Bank to either pay it to another bank or worse, from liquidity point of view, keep it privately. As some depositors cannot withdraw their money it results in destruction of a Bank’s credibility. Then even more depositors follow suit leading to a Bank’s collapse.

1. Full Reserve Banking

When a Bank retains all Deposits paid in, a Bank is not lending. It acts as a Product/Service Supplier of storing cash. This is also called 100% Reserve Banking.

For every $1 paid as Cash Deposit, Bank’s Loan/Deposit Balance Sheet shows Loan = $0, Deposit = $1, Cash Reserves = $1. Money Multiplier is 1 (i.e. in every day’s language money is multiplied by 1, i.e. it is not multiplied, no Credit is created).

Conclusion: Full Reserve Banking is a case of complexity of no growth (O(1)). Ignoring theft and fraud, the liquidity risk of Full Reserve Banking is 0% (i.e. 100% Deposits paid in are always in a Bank and can be withdrawn on demand at any time.)

2. Fractional Reserve Banking

When a Bank lends part of Deposits paid in, a Bank is Creating Credit. A proportion of a Loan to a Deposit from which a Loan is given is called Loan to Deposit Ratio (which may also be expressed in percentage terms: for example, LTD = 0.9 is equivalent to 90%.).

For example, for initial $1 paid in if the Loan to Deposit Ratio is LTD, a Loan given is $1 x LTD. Generally in the money-based economy it can be assumed that, on the whole, this Loan, $1 x LTD, will end up in a Bank as a Deposit and then it is re-lent again. Assuming the same Loan to Deposit Ratio, the next Loan is $1 x LTD2. Generally after n iterations from the initial $1, the Loan given is $1 x LTDn. Since LTD is less 1 (100%) then it is a regressive geometric series with limit 0 and the total Credit Created from the initial $1 Cash is $1 x 1/(1-LTD).

Money Multiplier is a ratio of Deposits on a Bank’s Loan/Deposit Balance Sheet to Cash Reserves accumulated. It tells us how many times Cash (narrow money) was multiplied by Credit Creation process (into broad money). Therefore based Loan to Deposit Ratio, LTD, we can calculate a Money Multiplier, MM. It is: MM = 1/(1-LTD). Money Multiplier tells us how many Deposited dollars on a Bank’s Loan/Deposit Balance Sheet are covered by $1 Cash.

For example, let LTD = 0.9 (i.e. 90%), i.e. MM = 10, then for every $1 of initial Cash Deposit (narrow money), the first loan is $0.9, the second $0.81, the nth $1 x 0.9n, the total value of Deposits on a Bank’s Loan/Deposit Balance Sheet is $10 and there are $9 of Credit Created (circulated in money-based economy) and Cash Reserves are $1.

Conclusion: Fractional Reserve Banking, with Loan to Deposit Ratio above 0 and below 1, is a complexity case of no growth (O(MM)) of a Bank’s Loan/Deposit Balance Sheets to underlying Cash Reserves as Money Multiplier is a constant number in relation to Loan to Deposit Ratio. We observe that it entails liquidity risk below 100%, since it is always possible that demand for withdrawals, at one time, exceeds Cash Reserves.

It is not a purpose of this paper to argue what level of liquidity risk is acceptable or beneficial for money-based economy and what factors ultimately determine this risk in reality. This may depend on many phenomena that affect human decision making process.

3. No Reserve Banking

We also observe that as Loan to Deposit Ratio is less than 1 and approaching it, the Money Multiplier tends to infinity, and nearly no Cash Reserves are created, the liquidity risk keeps increasing up to 100% at the limit. Nearly all the money paid in as Deposits are turned into Credits. Loans and Deposits tend to infinity on a Bank’s Loan/Deposit Balance Sheets, whilst Cash Reserves tend to remain finite and constant.

If Loan to Deposit Ratio is 1, at the limit, it is a linear growth of Loans and Deposits on a Bank Loan/Deposit Balance Sheet, Money Multiplier is infinity, Cash Reserves’ growth is 0 (i.e. they stay on the level which was when Loan to Deposit Ratio of 1 was started) and liquidity risk (in a finite time) tends to 100%. It is a case of trivial geometric series with common ratio 1 (which is also an arithmetic series).

Conclusion: No Reserve Banking is a complexity case of linear growth (O(n)) to infinity of both Loans and Deposits on a Bank’s Loan/Deposit Balance Sheet. A Money Multiplier is infinity resulting in liquidity risk of 100% in a finite time. No Reserve Banking is also called 0% Reserve Banking.

4. Depleting Reserve Banking

Depleting Reserve Banking, lending with Loan to Deposit Ratio above 1, is not possible, unless there are already Cash Reserves. It is, effectively, a Credit Creation with a “top up” from already existing reserves (this top up may come as a Loan from another bank’s reserves and a lending bank may consider borrowing bank’s debt papers as good as Cash). A Bank is Creating Credit by lending Deposits paid in and topping up from existing Cash Reserves (or a Loan from another bank’s reserves). A proportion of a Loan to an underlying Deposit is called Loan to Deposit Ratio.

For example, for initial $1 paid in if the Loan to Deposit Ratio is LTD, a Loan given is $1 x LTD. Generally in the money-based economy it can be assumed that, on the whole, this Loan, $1 x LTD, will end up in a Bank as a Deposit and then it is re-lent again. Assuming the same Loan to Deposit Ratio, the next Loan is $1 x LTD2. Therefore after n iterations starting with the initial $1, the Loan given is $1 x LTDn. Since LTD is above 1 (100%) then it is a progressive geometric series with exponential growth to infinity. The total Credit Created from the initial $1 Cash tends exponentially to infinity: $1 x ((LTDn – 1)/(LTD – 1))

As Loan to Deposit is above 1, and the geometric series is diverging, it is impossible to calculate Money Multiplier based on a ratio of Loans to Deposits on a Bank’s Loan/Deposit Balance Sheet at any one time. We also must know how many times a Deposit – Loan Cycle was executed at what Loan to Deposit Ratio. The general formula to calculate Money Multiplier (when Loan to Deposit Ratio is above 1) is:

i = 1, …. , n

LTDi is a Loan to Deposit Ratio

ki is a number of Deposit - Loan Cycles with a Loan to Deposit Ratio LTDi (LTDi+1 is a Loan to Deposit Ratio that follows LTDi).

It is a side note but we observe that it looks unlikely that Deposit – Loan Cycles (Credit Creation) starting with initial $1 Cash are uniform processes in money-based economy. Therefore it may be practically impossible to calculate accurate and reliable Money Multiplier when Loan to Deposit Ratio is above 1.

For example, let LTD = 1.17 (i.e. 117%) then for every $1 of initial Cash Deposit (narrow money), the first loan is $1.17, the second $1.3689, the nth $1 x 1.17n, i.e. for n equal 220 the 220th Loan value is over $1 x 1015. The total value of Deposits on a Bank’s Loan/Deposit Balance Sheet is over $5.8 x 1015 and there is also over $5.8 x 1015 Credit Created and circulated in money-based economy. Cash Reserves are initial Cash Reserves minus $5.8 x 1015. Money Multiplier is over 5.8 x 1015. In other words, whatever the initial Cash Reserves had been at the start of Credit Creation with Loan to Deposit Ratio of 1.17 (117%), after 220 Deposit – Loan Cycles executions, starting with initial $1 Deposit, the Cash Reserves were depleted by over $5.8 x 1015.

It is a side note but in practice banks’ Cash Reserves, on a Bank’s books, may be replaced with credit collaterals or other non-Cash financial instruments, being considered as good as Cash. This may result in, nominally, retaining any required reserve ratio, but this reserve would not be in Cash. These financial instruments are a part of Products/Services Supply and their market value/price (in Cash) depends on Products/Services Demand (Money Supply), see the graph on page 2.

Conclusion: Depleting Reserve Banking, with a Loan to Deposit Ratio above 1, LTD > 1, is a complexity case of exponential growth (O(LTDn)) of a Bank’s Loan/Deposit Balance Sheets to underlying Cash Reserves. As Money Multiplier tends to infinity the liquidity risk is 100% in a finite time.

5. Brief computational complexity analysis summary

Let us consider Credit Creation as an algorithm that we would like to implement on a computer. (It is actually a very basic algorithm.)

The cases of Full Reserve Banking and Fractional Reserve Banking, of O(k) where k is a constant equal 1/(1 - LTD), are tractable algorithms. They can be considered as contained algorithms: the requirement on resources is a constant multiple of an underlying parameter of Credit Creation (i.e. Cash).

No Reserve Banking (of O(n)) is also a tractable algorithm but it takes more resources than Full Reserve Banking or Fractional Reserve Banking. In fact it would be a case of concern that at some point, in linear time depending on a number of executions of Deposit – Loan Cycles, the demand on resources will eventually exceed availability threshold. This is non-containable case as there is no upper limit of demand on resources in relation to underlying parameter of Credit Creation (i.e. Cash).

Depleting Reserve Banking, of O(LTDn), is an intractable algorithm. The growth of demand on resources is exponential. This type of algorithms is considered impractical for implementation on computers. (In general, in computer science algorithms with complexity above polynomial are not accepted as general solutions to underlying problems.)

In the cases considered above, containable algorithms of Credit Creation present liquidity risk below 100%. They are of manageable risk as a part of a risk portfolio. Non-containable algorithms present liquidity risk of 100% in a finite time, i.e. it is unmanageable risk as liquidity shortage is a matter of a finite time. In the case of Depleting Reserve Banking, due to exponential growth of a Bank of Loan/Deposit Balance Sheet and Money Multiplier (and also exponential depletion of Cash Reserves) such finite time is assumed to be very short: short enough, in practice, for the liquidity shortage to occur. By computational complexity standards, Credit Creation using Depleting Reserve Banking is intractable, i.e. non-practical for implementation.

6. Depleting Reserve Banking and loss of control of Money Multiplier

Essential to managing liquidity risk is the knowledge of Money Multiplier (MM), i.e. how many dollars of Deposits on banks’ Loan/Deposit Balance Sheets are covered by $1 Cash. As already showed in the preceding sections of this article, if a Loan to Deposit Ratio is always below 1 then the total value of Deposits and total value of Loans on banks’ Loan/Deposit Balance Sheets are the basis for calculation of Money Multiplier: MM = Total Deposits/(Total Deposits – Total Loans).

If Loan to Deposit Ratio is above 1 then the above equation does not hold. In order to calculate Money Multiplier we need more information about each Deposit – Loan Cycle (which may be impractical or even impossible to gather). This is even more complicated: it is possible to execute any number of Loan – Deposit Cycles with Loan to Deposit Ratio above 1 (achieving any arbitrary high Money Multiplier in this process) and then with one cycle only reduce a ratio of total value of Loans to total value of Deposits below 1 on a Bank’s Deposit – Loan Balance Sheets. This may look like an “average” Loan to Deposit Ratio below 1. However this value used in the formula presented above, MM = Total Deposits/(Total Deposits – Total Loans), will not produce a true value of Money Multiplier (most likely, in practice, a real Money Multiplier will be much higher).

Therefore, concluding this computational complexity analysis, Credit Creation with Loan to Deposit Ratio above 1 must not be practiced since:

  • exponential growth of banks’ Loan/Deposit Balance Sheets is intractable
  • liquidity risk, in a finite time, is 100%
  • practical macro control of growth of Money Multiplier is lost

It is a side note but due to exponential growth of a Bank’s Loan/Deposit Balance Sheet and exponential depletion of reserves, Depleting Reserve Banking is a classic example of a pyramid scheme.

It is also a side note but the present liquidity crisis and resulting economic crisis was preceded by a prolonged period of Credit Creation with Loan to Deposit Ratio above 1.

7. Consequences of Depleting Reserve Banking on Mark-to-market and Value-at-risk (VaR)

Depleting Reserve Banking results in Money Multiplier growing at exponential pace without any upper bound (i.e. infinity is the limit) such that each unit of cash has to satisfy ever growing demand on banks balance sheet. In a finite time (in practice, due to exponential growth, very short time), banks run out of cash to service their payment obligations like deposit withdrawals: all cash becomes tied to servicing such obligations and the shortage keeps growing presenting liquidity shortage. Consequently there is a decreasing volume of money (cash) to pay of any non-cash financial (and other) products. This volume decreases at exponential pace (i.e. practically very fast) to zero [as Money Multiplier grows at exponential pace to infinity, cash available to service non-cash obligations decreases to zero]. Hence a Mark-to-market price of any non-cash financial products also decreases to zero, as there is a decreasing volume of cash available to complete a transaction. In such scenario a probability of a non-cash asset losing 100% of its value in a finite time tends to 100%. In other words, as a result of Depleting Reserve Banking, for any arbitrary high loss less than 100% of a non-cash asset, there is always a finite time horizon (in practice, due to exponential characteristics, very short) such that probability of such loss is 100% (it is a certainty).

Conclusion: The effect of Depleting Reserve Banking is such that, if continued, it turns all non-cash financial products into worthless assets (so-called “toxic waste”): Value-at-risk (VaR) as a loss of 100% of a value of non-cash financial products is practically 100% in a finite time.

8. Financial perpetuum mobile

Depleting Reserve Banking (i.e. Credit Creation with Loan to Deposit Ratio above 1) can lead to unusual, unintuitive effects. As noted above a Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. It is not typical for a Bank’s customer to expect to be paid more in interest on a Deposit put in a Bank than to pay for a Credit taken out. It is even less typical to expect a Bank to make a profit in such a scenario. It would be a perfect business model, “win – win “, for a customer and a Bank: financial perpetuum mobile.

Let L be a Loan taken by a Bank customer which she immediately deposits in a Bank. Let I1 be an Interest Rate paid on a Loan by a customer to a Bank and I2 be an Interest Rate paid on a Deposit by a Bank to a customer. I1 < I2. Let D be a total Deposits accepted by a Bank from which it Creates Credits, C = D x LTD. Let LTD > I2/I1. (A customer’s Deposit and Loan, both equal L, are, in practice, much smaller than D.)

Customer’s perspective:
L x I2 - L x I1 = L x (I2 – I1) > 0: since I2 > I1 a customer makes profit.

Bank’s perspective:
C x I1 - D x I2 = D x LTD x I1 - D x I2 = D x (LTD x I1 – I2) > 0: since LTD > I2/I1 a Bank makes profit too.

A Bank is making profit since it is lending out more than is taking in Deposits with LTD > I2/ I1. But such lending is unsustainable: it can only last as long as Cash Reserves are sufficient to top up Loans. However Cash Reserves are depleting at exponential pace. Hence this financial perpetuum mobile will have to come to a halt.

Sunday, 21 March 2010

From bail-in to bail-out: letter to The Economist

On 28 January 2010 The Economist published a guest article authored by Messrs Paul Calello, the head of Credit Suisse' investment bank, and Wilson Ervin, its former chief risk officer, who proposed a new process for resolving failing banks, "From bail-in to bail-out".

On 3 February 2010 the author of this blog sent the following letter to the Editor of The Economist. The reader are invited to draw their own conclusions why it was not published.


To the Editor of The Economist


The "bail-in" proposed by Paul Calello and Wilson Ervin "bail-in" "From bail-out to bail-in" fails to address the real reason for the banks' liquidity crunch: that the loan to deposit ratio was greater than 100%, creating rapid growth via the money multiplier (which every economics student studies as the process of "deposit creation"). This makes a liquidity risk a certainty, a probabilistic inevitability. When the banking system's exploding liabilities outstripped their ability to get hold of cash, central banks stepped in, in effect printing money to restore banks' liquidity through quantitative easing.

The Calello-Ervin proposal does not deal with this. It does not state at what level the money multiplier would be sustainable and how to keep it below that limit. Instead, it spreads the liquidity risk among shareholders and creditors of different financial institutions, meaning that the next (and inevitable) credit crunch will be more severe and still more widespread than the one at the end of 2008.

An analogy would be a tank in which gas pressure is growing at an uncontrolled rate. Making the tank stronger only delays the inevitable (and much larger) explosion.

In short, "innovative" risk management mechanisms such as the Calello-Ervin proposal cause more harm than good, rather as credit-default swaps have done.

Yours sincerely

Greg Pytel

Saturday, 20 March 2010

Nothing happened

In his article "Against All Odds", Daniel Gross is trying to prove that, very likely, "AIG might just pay the Fed back" the costs of the bailout. He concludes: "Nobody at Treasury or the Fed is bold enough to predict that taxpayers will ultimately be made whole. Some rough math suggests that final cost to the taxpayers for the AIG debacle could be between $12 billion and $20 billion. Yes, that’s a bitter pill to swallow. But it’s a much smaller pill than we have imagined even a few months ago."

Mr Gross' analysis and arguments are supported by pretty detailed calculations. Yet his "rough math" has the major flaw. It does not take into account the costs of the downturn of the economy caused by the financial crisis in which AIG played a key role. The financial crisis is not really a crisis but, as shown in the seminal article on this blog, a collapse of the pyramid scheme engineered in order to funnel cash from the economy into individuals' hands. The costs of the economic downturn go into trillions of dollars in national budgets’ deficits and far more if we were to add losses of individuals and families that lost their jobs and homes.

The enormity of the current global financial mayhem that will be paid for by generations to come brings a question about a true motivation of publishing articles painting a rather rosy picture as if nothing really has happened.

Saturday, 13 March 2010

Money creation and circulation in the economy

(This is a draft version of an article. Therefore any comments, corrections and suggestions for improvement are welcome as they will be used to improve it.)

1. Money in economic universe

Economy universe consists of two sets of processes:

  • Products/Services Creation, Trading and Consumption /Destruction

  • Money Creation, Multiplication and Destruction

They interact in the following way:

- all Products/Services (including financial) are Supplied onto the Marketplace

- Cash (narrow money) is as the medium of exchange and store of value

- through Market Transactions such as producing goods, selling/buying goods, destroying (consuming) goods, selling/buying services, consumer banks operations (depositing money in a bank, lending money by a bank, withdrawing deposits, paying back loans)

- Credit Creation by circulating Cash through Deposit – Loan Cycle: by accepting Deposits and Lending them out, money is circulated in the economy multiplied in the process (also sometimes referred to as broad money), this is reflected on Loan/Deposit Balance Sheets and Cash Reserves; Loan to Deposit Ratio defines Money Multiplier (an underlying attribute of Credit Creation)

- Central Bank operations such as Creating or Destroying Cash, setting up Interest Rates, Open Market Operations, lending as the Lender of Last Resort

The graph below shows the structure and flow of money in the economy:

Economic universe has the following characteristics:

- ownership/supply of Product/Service

- value/price of Product/Service

- Cash Reserves and Loan/Deposit Balance Sheets

- Credit Creation (Deposit – Loan Cycles) information

2. Economic activities

An economic activity is a Market Transaction which is a transfer of ownership/supply for a price or Depositing or Lending money through as a Deposit – Loan Cycle (Credit Creation).

The model presented on the graph above separates and abstracts a Service of depositing and lending money from a process of Multiplying Money, i.e. Credit Creation, which is a result of lending deposits out. The former is modelled on the graph by a Market Transactions process (of Supplying a Product/Service) while the latter is modelled by Credit Creation. This a dual role of a bank as a Credit Creator and, possibly through it, as Product/Service Supplier is central to money creation and circulation in the economy.

2.1 Products and Services Demand and Supply

Products and services are created and they are ready for sale on the market in exchange for money. This constitutes Supply and Demand characteristics whose balance may be described, for example, by a Fisher’s “Equation of Exchange”, MV = PT. As an example we can observe that if we do not control the growth of Supply of Products and Services (due to its complex structure, natural and unpredictable phenomena, etc.) and we control growth of Money Supply (for example by setting Interest Rates or controlling Loan to Deposit Ratio) then additional Money Supply, through Credit Creation, will result in inevitable Inflation to balance Supply with Demand. A gradual increase of Demand results in gradual increased economic activities to satisfy it on a Supply end.

It is not a purpose of this model to argue the correctness of any theory or equation of Supply and Demand but to show that the model presented in this paper can accommodate any Supply and Demand theory.

2.2 Market Transactions

Money received for provision of Products/Services is either held outside of a Bank e.g. by a Product/Service Supplier), spent on Products/Services (Direct Cash Exchange, No Credit Creation) or is Deposited in a bank (in a form of Deposit or repayment of a Loan previously obtained).

2.3 Credit Creation (Deposit – Loan Cycle)

Banks (modelled as Bank on the graph above) provide Deposits back to the market (to depositors: Deposits paid out) or give loans (to creditors: Loans given), which is Credit Creation. Loans are given using Fractional Reserve Banking method. In extreme cases:

- if Loan to Deposit Ratio is 0% then effectively no loans are provided only deposits paid in are paid out to depositors (Cash Reserves equals liabilities on Loan/Deposit Balance Sheet); in such case a Bank is a store of Cash (in other words Cash Reserves are 100%). This is called Full Reserve Banking (or 100% Reserve Banking).

- if Loan to Deposit Ratio is 100% then all Deposits are turned to Loans and no Cash Reserves are created. This is called No Reserve Banking.

In the first instance, banks do not play a role as a (re)-lender but are a store for money. In the second instance (no Cash Reserves are accumulated to secure demands of depositors to pay out), if loans were 100% secure repayable on demand then such a model could have practically functioned. Typically banks lend with Loan to Deposit Ratio between 0% - 100%. For example, if Loan to Deposit Ratio were 90% than for every $10 on the Loan/Deposit Balance Sheet of liabilities banks accumulated $1 Cash Reserves, i.e. Money Multiplier is 10.

Such a model is possible to function in practice, since money is circulated through banks and not all depositors demand money at the same time, only a fraction of liabilities (on Loan/Deposit Balance Sheet) need to be satisfied at any one time. However, since there are demands on Deposits to be paid out and some creditors may default (not pay back a Loan) Cash Reserves are necessary. Inter-bank lending makes the system function as one big bank balancing supply and demand of liquidity by different banks. Furthermore a role of Central Bank is to act as a Lender of Last Resort in the event that banks’ Cash Reserves are not sufficient to satisfy demand for Deposits withdrawal (State guarantees of Deposits play an ultimate role in a credibility of such system, which works as a statistical machine).

It is not a purpose of this paper to argue a safe or practical level of Loan to Deposit Ratio which determines Money Multiplier and Cash Reserves level (or that Fractional Reserve Banking with Loan to Deposit Ratio above 0% should be accepted as a model). We observe that it is a philosophical debate what level of risk the society should accept, similar to safety of road, train or air travel, or nuclear power stations. We observe that the higher the Loan to Deposit Ratio the larger the Money Supply in economy, however at the same time, the greater the risk of liquidity shortage as the size of Cash Reserves are relatively smaller to overall banks’ liabilities on Loan/Deposit Balance Sheet.

2.4 Central Bank’s role

Apart from acting as the Lender of Last Resort, a role of Central Bank¸ as a creator of Cash (narrow money), is to set control on Money Supply (through Credit Creation) by setting an Interest Rate and acting through Open Market Operations. For example, a higher Interest Rate encourages saving and discourages borrowing thereby reducing Money Supply by reducing volume of Credit Creation, i.e. amount of broad money in circulation. This, in turn, reduces Products/ Services Demand which reduces pressure on Supply, typically resulting in reduction of Inflation. This, in turn, usually results in reduction of Interest Rates by Central Bank. This is a balancing act that a Central Bank plays (in practice, typically using principles behind MV = PT equation as a guide).

3. Additional comments

3.1 Financial Products/Services

Financial (banking) Products/Services are considered like any other Product/Services in the economy. There is no reason to consider them differently: they are simply Products/Services sold as a part of Market Transactions. The importance of banks’ role as Credit Creators (by executing Deposit – Loan Cycles) suggests that if banks collapse the economy will collapse too. Whilst this may be reasonably assumed as a correct hypothesis, this does not make banks unique suppliers of Products/Services in the economy. For example a collapse of electricity producers/suppliers or water producers/suppliers would bring economy to a collapse too. Therefore whilst banks role may be seen as vital, it is not unique.

In this context we separated and abstracted banks’ role as Credit Creators (through Deposit – Loan Cycles) and a role of Product/Services Suppliers.

- when a bank issues a Loan out of a Deposit, on one side it Creates Credit AND, at the same time, it is selling a Product/Service (provision of a Loan) for which a Creditor pays;

- when a bank accepts a Deposit (which may be later issued as a Loan), on one side it makes the first step in Credit Creation AND, at the same time, it is buying a Product/Service for which it pays a Depositor. We consider a Depositor as a Lender to a bank (i.e. a bank is a Creditor to a Depositor).

As noted before, this approach separates and abstracts a mathematical process of Money Multiplication (resulting from Loan to Deposit Ratio above 0%) from a Products/Services Supply of lending money (and other financial Products/Services). A Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. Pensions, endowments, savings, wholesale funding, insurance policies, derivatives and so on are financial Products/Services.

3.2 A role of a State in the model

In this description there is no reason to separate a State impact on economy from other providers of Products/Services. For example, taxation is a Market Transaction whereby taxpayers pay for Products/Services delivered by a State. (Whether efficiently or not is another matter and this question also applies to privately sold Products/Services.) Government bonds are financial products sold on the market. For avoidance of doubt, this model does not imply or support any argument whether a “larger State” is better than a “smaller” one, the State sector is as efficient as private sector etc. It also does not imply that such Market Transactions are voluntary (in some case like payment of taxes or law enforcement services, clearly they are not).

4. Economy dynamics

At any point in time a state of the economy is characterised by a set of information about it. This would include all the information at every level of economic activity: all information about every single Product/Service, its price/value, amount of money in circulation and its allocation, Loan/Deposit Balance Sheet, Cash Reserves, Interest Rate and so on. Any economic activity in such a system is a transition from the existing state to a new one. Examples of transitions to a new state:

- a Product or Service is sold at a certain price

- a new product is offered on the market at a certain price

- a prospective buyer of a service agrees a reduction of a price

- such a buyer (as above) completes a transaction

- a bank lends money to a borrower

- a borrower repays (a part) of a loan

- a deposit is made money in a bank

- Central Bank changes an Interest Rate

- … and so on

In general a transition from one state to another, changes the information defining ownership/supply of Product/Service or value/price of Product/Service or Creating Credit or other attributes in the model.

We can consider any economic activity as a transition from one state of economy to a new one. Some economic activities may be null transitions, i.e. result in no change to information about the state of the economy. For example, a re-evaluation of the price of a Product/Service resulting in the same price is an example of a null transition.

The presented model does not imply whether deposits create loans or vice versa. This is akin to “chicken and egg” dilemma. Money circulation is of cyclical nature with iterative or recursive characteristics and description has to start somewhere which may possibly give a wrong impression of any assumed starting point of a cycle. In the context of this model it is a purely philosophical issue of no practical consequence.