Money and Banking

ISBN 978-0-9935483-1-4

Money and Banking was written just after the Financial Crisis of 2007-2008. The Preface follows:

There are many texts on mathematics for economists but virtually none that seek to present financial theory and the relevant areas of economics to mathematically mature readers at an introductory level. The present text seeks to remedy that deficiency while at the same time giving a challenging view of a subject where recent events have led to a widespread search for new approaches that move away from orthodox and traditional perspectives.

This book makes no pretence to be a conventional textbook. The recent Financial Crisis has prompted many writers to question the established Efficient Markets Hypothesis as having proved hopelessly unable to anticipate the Crisis. Although I hardly touch on the EMH in this book, I have found myself asking a lot of questions that the established texts simply don’t even ask, let alone answer. Put bluntly, to a scientist economic theory doesn’t look scientific. The trappings are there, but the fundamentals are not.

The genesis of the book couldn’t be simpler: I wanted a book like this, I couldn’t find one, so I wrote one.

Coming from a different background has its advantages and its disadvantages. The biggest advantage was that I was able to cast the subject in a clear well-defined framework from the start, so I knew exactly what information I wanted. From this foundation I expected quite rapidly to build a clear picture of how modern financial systems work. But in the event, despite exhaustive trawling through the established texts, there are questions to which I simply cannot find answers. I profoundly doubt whether most economists or even practising bankers would know the answers to most of them because in the conventional analysis, it’s simply never occurred to anyone to ask many of them.

So I have decided to leave these questions open, and the book has a website which provides an open forum for discussion of them, and if anyone knows the answers, I will be very grateful if they can supply them. Typical are the simple basic statistics of aggregate stocks and flows that provide a complete overview of the entire pattern of trading in the world’s financial markets. In starting on Chapter 9, I imagined that these most vital of all economic figures would be easily and widely available, and I set out Tables at the end of the Chapter to fill them in, expecting this to be at most half a day’s work. But after some weeks of trying, I had to admit defeat! Without these key figures, economics is as useless as astronomy without stellar and galactic distances, yet they seem either never to have been seriously collected, or buried in deliberate secrecy.

So this is as much a book that asks as a book that tells. I am convinced that financial theory can be placed on a much surer footing than it is at present, but traditional economics persistently fails to ask the right questions. Only since the present Financial Crisis has it finally come to be widely accepted that methods that work for goods markets give quite the wrong impression for asset markets, and if we’re to try to understand the instability of the system we all have to live in, it’s asset markets that must be understood. There’s a lot of work under way in this direction already, but I would hope that by asking the questions I’m asking and reviewing how far established methods go to answering them and how far they don’t I can give this work a boost.

Of all the puzzles that I have found, two central issues stand out.

The first is that to understand a monetary economy, it’s essential to know exactly how banks actually do their accounting internally, because this is the lynch pin around which the entire monetary system revolves. The existing treatments seem to regard this as a minor detail, much in the tradition of “money is merely a veil” but it’s far from it. Slight differences in the mechanics of the system here could have huge repercussions. Despite repeated attempts, I have been quite unable to find a text that describes accounting strictly as it is practised within the banking industry, a point echoed by another exasperated reviewer in Amazon on the same mission.

My second key thesis is that economic analysis has to break away from being centred around the agents of the system. It’s almost unimaginably compelling to feel that because we are ourselves the agents that drive all economic behaviour, we can dismiss the need for a lot of the scientific objectivity that created the Scientific Revolution of the Seventeenth Century. After all, we know how market participants think and work, so we can cut a lot of corners by using that foreknowledge to inform our analysis. I strongly believe that Walras saw the error in this, and so did Keynes, but they hit the same rocks of misinformation that we find today! Put very basically, the essentially unknown and unpredictable whims of market participants can explain anything but predict nothing, and basing analysis on such postulates is simply not science.

In Chapter 10, I outline how one of the most important attributes of negative feedback systems in technology is that, by and large, they eliminate the vagaries of the amplifier itself, and that is what makes them work and makes them stable. In economic systems, the nearest thing to the amplifier is the agent or market participant, and we need to develop an analysis that eliminates the vagaries of these agents rather than trying to “guesstimate” them. By analysing the evolution, over time, of economic systems in aggregate, we should be able to dispense with the need to analyse the essentially unpredictable agents and so produce a truly objective and scientific theory of economics.

This is how I would interpret Keynes’s paradigm of “macro” economics, but if my own researches are anything to go by, eighty years later we have only the sketchiest notion of the values of the basic economic aggregates from which any such analysis would have to start.

Monetary economics has in the main been developed by deeply honest and idealistic intellectuals who are trying to fathom the behaviour of people who are commonly compulsive gamblers and at worst out and out scoundrels. Reading around such a subject, I’ve found it difficult to avoid the occasional facetious remark, either about the shocking behaviour of the financiers themselves, or the naivety of their academic analysts, but economists do have my sympathy in that, unlike workers in the physical sciences, economists are almost certainly being deliberately misled by much of Government, of Wall Street and of the City as financial institutions are notoriously evasive and reticent about their affairs and this evasiveness may go back centuries.

In the event, although I’ve toned down or eradicated the worst of the outbursts I gave way to in the assembling of these notes, I’ve not expunged all the comments, as I feel a certain amount of humour helps to lighten any mathematical or technical text, and I would like my asides to be seen in that light. My concern is to stimulate discussion and rethinking.

The book falls naturally into two parts, corresponding to the two fundamental questions cited above. Chapters One to Seven focus on the actual mechanics of money and financial markets, beginning with a simple logical definition of money in Chapter One that avoids the rather hazy multi-faceted introduction that appears in most textbooks. This simple model suffices to outline most of the basic financial instruments such as bonds and options, as I show next. I then explain how double-entry bookkeeping works as a parity check, and explain what I think Walras was driving at in his model of markets.

Chapter Two outlines the workings of the retail commercial banks and discusses the curious double-level phenomenon of the payment mechanism and its historical origins, and the creation of money.

Chapter Three gets into Forex, being careful to keep to a neutral viewpoint of how currencies should be valued and exchanged against each other, strictly avoiding the idea of “ours” and “theirs”! This chapter closes with a brief comment on Balance of Payments statistics.

The next chapter briefly deals with central banks from a strongly historical viewpoint, and shows how the US Federal Reserve is now much more open and informative about its workings than the Bank of England is!

Chapters Five to Seven deal with the standard theory of financial instruments, covering Money Markets in Chapter Five, Bonds in Chapter Six and Derivatives in Chapter Seven. Because there are many good books on this area we’re on pretty sure ground here, although questions of detail remain.

The second part of the book looks at how economic theory attempts to understand the dynamics of money, working from its traditional foundation of supply and demand. I point out that this theory, developed for goods markets, may need substantial revision for asset markets in which instability is much more commonplace, and that it can be forcefully argued that the theory has serious shortcomings anyway, these being summarised in my remarks above. Chapter Eight is devoted to Supply and Demand, and sketches out the basic theory, the Slutsky equation, and touches on Pareto optimization and Say’s supply-side model.

Chapter Nine is a cri-de-coeur for more information! It sketches out the basic figures that I would like to have for Stocks and Flows and how I would like to see them defined, but the actual figures I have been unable to obtain. This chapter seemed a good place to introduce the Quantity Theory of money too.

Chapter Ten outlines the basics from which I would expect a full dynamic theory to develop, starting with the popular cobweb model, and going on to show something of how this sort of theory has been hugely developed in control systems engineering using Laplace and z transforms. It goes on to touch on the significance of feedback and how in a negative feedback system the behaviour of the core amplifier – precisely the thing that is so hard for economists to evaluate – effectively drops out of the overall system response, the key point I made above.

Chapter Eleven develops various simple simulations of asset markets, showing how quite simple models can approximate the observed behaviour surprisingly well. This chapter also includes a brief discussion of News Theory in Forex, and the last simulation is of the property market, a market that requires special consideration.

Chapter Twelve closes the book with a discussion of the recent Financial Crisis and various others that led up to it, and builds up to a polemic that we really need a massive overhaul of our financial machinery, which of course, as Milton Friedman said, we’ve no chance of getting. Injustice will prevail!

I’ve left the book much as it was written finishing in December 2012, while the Financial Crisis was still very much with us, making only minor corrections. The fundamental defects that precipitated the Crisis are still of course with us too, governments having little real interest in correcting them.

Table of Contents

Chapter One 1

Money 1

1.1 Introduction 1

1.2 Connected Transactions 3

1.3 Accounting Checks 10

1.4 Walrasian Markets 12

1.5 Summary 17

Chapter Two 19

Banks 19

2.1 The Keepers of the Accounts 19

2.2 The Two-Level System and the Payment Mechanism 20

2.3 Fractional Reserve Systems 24

2.4 A Simple Bank Balance Sheet 34

2.A Appendix: Could mirroring work recursively? 38

2.B Appendix: The traditional argument for the Credit
Multiplier 41

Chapter Three 45

Multiple Moneys 45

3.1 Currencies 45

3.2 Rates of Exchange 46

3.3 Parities 56

3.4 The Balance of Payments 60

Chapter Four 65

Central Banks 65

4.1 Base Money and Cash 65

4.2 Banknotes 66

4.3 Liquidity Crises 69

4.4 Balance Sheets of the Central Banks 71

4.5 The Workings of Central Banks 77

4.6 A Note on the US Treasury’s Involvement 80

4.A Appendix: The Bank of England Return 31 July 1929 82

Chapter Five 83

Money Markets 83

5.1 Introduction 83

5.2 The Bill of Exchange 84

5.3 Present Value 86

5.4 LIBOR and LIBID 88

5.5 Certificates of Deposit (CD’s) 90

5.6 Commercial Paper and Treasury Bills 93

5.7 Repo 95

5.8 A Note on other Money Market Instruments 98

5.9 How do Money Markets enable Banks to balance their
books? 99

Chapter Six 103

Bonds 103

6.1 Introduction 103

6.2 A Survey of Bond Types 104

6.3 Clean and Dirty Prices 106

6.4 Bond Valuations 108

6.5 Duration and Convexity 114

6.6 Yield Curves 117

Chapter Seven 125

Derivatives 125

7.1 Introduction 125

7.2 Futures and Margins 126

7.3 More on Futures 131

7.4 Options 136

7.5 Options and Margins 141

7.6 Valuation of Options 143

7.7 Swaps 152

7.8 Credit Default Swaps 155

7.9 Securitisation 158

Chapter Eight 165

Supply and Demand 165

8.1 Introduction 165

8.2 The Simplest Case 166

8.3 Costs and the Supply Function 171

8.4 Utility Functions 181

8.5 The Slutsky Equation 187

8.6 Criticisms of Supply and Demand Theory 191

8.A Appendix: Homogeneous Functions 194

8.B Appendix: Introduction to Lagrange Multipliers 197

Chapter Nine 201

Stocks and Flows 201

9.1 Introduction 201

9.2 Definitions of Stocks and Flows 204

9.3 The Quantity Theory of Money 208

9.4 Stocks and Flows of Financial Instruments 212

9.A Appendix A: Stocks and Flows in World Markets 215

9.B Appendix B: Stocks and Flows in US Markets 216

9.C Appendix C: Stocks and Flows in UK Markets 217

9.D Appendix D: Stocks and Flows in European Markets 218

Chapter Ten 221

Dynamics 221

10.1 The Need for a Dynamic Theory 221

10.2 The Cobweb 222

10.3 A More Subtle Cobweb 231

10.4 Control Systems Engineering 235

10.5 Feedback 241

10.6 Stochastic Approaches 250

Chapter Eleven 253

Dynamics of Asset Markets 253

11.1 Introduction 253

11.2 A Speculators’ Market 254

11.3 News Theory in Forex 261

11.4 Property 267

Chapter Twelve 273

The Financial Crisis 273

12.1 Introduction 273

12.2 Off-Balance-Sheet Finance 277

12.3 The 1997 Asian Crisis 282

12.4 Long Term Capital Management 1998 283

12.5 Northern Rock 2007 288

12.6 Lehman Brothers 2008 291

12.7 Conclusions 292

12.A Appendix: Could we Return to the Gold Standard? 300

Select Bibliography 303

Index 305